FRANKFURT — The European Central Bank took a long-awaited step Thursday to raise interest rates in response to the record inflation that has inflicted a massive cost-of-living crisis across the region.
By opting for half a percentage point, rather than the quarter percentage point it previously flagged, the bank sought to send a clear signal of its inflation-fighting resolve. Its decision came amid rising market jitters about Italy’s fresh political crisis following Prime Minister Mario Draghi’s resignation.
The ECB has lagged most major central banks on countering inflation, which climbed to a record high of 8.6 percent in the eurozone in June. Thursday’s 50-basis-point move — the first hike of that size in more than two decades — aligns the Frankfurt institution more closely with its counterparts, which have moved in 50- and 75-basis-point steps.
The Governing Council “judged that it is appropriate to take a larger first step on its policy rate normalization path than signalled at its previous meeting” in view of its updated inflation outlook, the policy committee said in a statement. Looking ahead, “further normalization of interest rates will be appropriate,” with the future rate path to be decided meeting-by-meeting and depending on incoming data, it added.
Taking effect next Wednesday, the interest rate on the main refinancing operations, the marginal lending facility and the deposit facility will be increased to 0.50 percent, 0.75 percent and 0.00 percent, respectively.
The euro — which recently had slumped to parity against the U.S. dollar — jumped to 1.027 against on the announcement before easing to around 1.019 after ECB President Christine Lagarde concluded her press conference.
In her comments to journalists, Lagarde stuck to the Governing Council’s open-ended language and refused to say how likely another 50-basis-point move would be in September, when it meets again. That raised some eyebrows among ECB watchers.
“The ECB seems to have abandoned its attempt to provide much relevant and reliable advance guidance to markets,” quipped Berenberg economist Holger Schmieding.
Not too rosy
The latest data hasn’t given the ECB much cause for optimism. And Lagarde acknowledged as much, warning that Russia’s war on Ukraine is an ongoing drag on growth — while inflation may accelerate even more than previously thought.
On top of those risks, the eurozone has to face the prospect of spiraling borrowing costs in some of its weakest and most heavily indebted members — a threat that could get worse as interest rates go up.
To address those concerns, the Governing Council unveiled an anti-crisis bond-buying “tool” — formally known as the Transmission Protection Instrument (TPI) — that aims to address spikes in bond yields of countries beyond what the underlying economic conditions would warrant. The bolder rate hike, according to some analysts, was agreed on as part of a deal to get support for the TPI — although Lagarde emphasized Thursday that the TPI decision was unanimous.
ECB policymakers, for their part, backed the TPI as necessary to support the effective transmission of monetary policy.
“The TPI will ensure that the monetary policy stance is transmitted smoothly across all euro area countries,” the Governing Council said. “The singleness of the Governing Council’s monetary policy is a precondition for the ECB to be able to deliver on its price stability mandate.”
But the elephant in the room was Rome’s political turmoil following Draghi’s resignation, which sent shock waves through eurozone sovereign bond markets. That could mean borrowing costs will spike in some member states, making it harder for the ECB to raise rates and deliver on its price stability mandate.
Lagarde carefully avoided answering questions on what the new tool may imply for Italy or whether it may treat the latest rise in spreads as justified, driven by Rome’s unwillingness to implement needed reforms.
Instead, she spelled out that the ECB can activate the tool to counter unwarranted market disruption that poses a serious threat to the transmission of monetary policy to any eurozone member state. She also emphasized there will be no ex-ante limits to the ECB’s purchase of bonds — and the scale of support will depend on the severity of the risks facing policy transmission.
The Governing Council, meanwhile, said it will look at a slew of indicators to assess the drive behind rising spreads. Countries are eligible for bond purchases under the TPI only if they comply with the EU fiscal framework and have no severe macroeconomic imbalances. They must also show fiscal sustainability and pursue sound and sustainable macroeconomic policies.
Lagarde’s ‘whatever it takes’ moment
The launch of the tool comes 10 years — almost to the day — after Draghi, Lagarde’s predecessor, promised to do “whatever it takes” to safeguard the integrity of the euro. On Thursday, though, the onus was on Lagarde. The market reaction, which saw Italian spreads rising to 247.7 basis points from a daily low of 207.40, suggests that she might yet have some convincing to do.
What Lagarde did manage to achieve, as opposed to Draghi, was “consensus” on the Governing Council for the 50-basis point increase and unanimity for the new tool — even after hawks previously expressed concerns over renewed bond market interventions.
“Today’s change of mind shows that the hawks must have gotten cold feet, fearing that the promised higher-than-25bp rate hike in September would be washed away by the looming recession. The agreement on a TPI had to be paid for by the doves with a stronger rate hike today,” ING economist Carsten Brzeski said.
And tensions may still lay ahead. The Governing Council will have a lot of discretion when activating the program. As European University Institute Professor Sony Kapoor put it on Twitter: “The touting of ‘unanimity’ by Lagarde at the ECB press conference was basically meaningless! These conditions for TPI are such that governing council conflicts have simply been postponed most likely to times full of financial stress and market volatility.”
Lagarde stressed that the tool “has been designed carefully with adequate attention paid to the safeguards that are necessary for that instrument to be valid.” But at least outside the Governing Council, the TPI, if ever deployed, will spark controversy.
The tool “is dangerously close to monetary state financing,” German MEP Markus Ferber of the center-right European People’s Party said in a statement after the decision. “Lagarde can refer to the transmission mechanism as much as she wants — there is still no good monetary policy explanation for this new program. Sooner or later, the European Court of Justice will have to have a look at this tool.”
Lagarde likely had those warnings in mind Thursday, noting that the Governing Council would rather not ever deploy its shiny new tool.
But akin to Draghi’s tough stance at the height of the eurozone crisis, she stressed the ECB’s readiness to act if needed. “We will not hesitate,” she insisted.
This story has been updated.
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