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European Central Bank raises interest rates amid inflation

, July 21, 2022, 0 Comments

The bank has ended an era of negative interest rates with a higher-than-expected hike. The move could put a brake on rising prices but might also dampen economic growth.

ecb-european-central-bank-marketexpress-inThe European Central Bank on Thursday raised its key interest rates for the first time in over a decade. The move is aimed to combat inflation as consumer prices in the eurozone rose at an 8.6% annual pace in June.

The ECB raised its negative benchmark deposit rate by 50 basis points from minus 0.5% to 0%, lifting the bank’s deposit facility out of negative territory for the first time in eight years.

The announcement came as a surprise as the bank had initially hinted that it would hike the rate by 25 basis points only.

ECB cites inflation

The ECB justified the bigger hike by an “updated assessment of inflation risks” and pledged further action possibly as soon as its next meeting in September.

“At our upcoming meetings, further normalization of interest rates will be appropriate,” said ECB chief Christine Lagarde.

Moving away from negative interest rates “allows us to make a transition to a meeting-by-meeting approach to our interest rate decisions,” Lagarde added.

The ECB targets an inflation rate of 2% as its maximum, but had been keeping its interest rates to historic lows for years. The previous stance was calculated to encourage growth in the eurozone economy battered by several national debt crises, the COVID pandemic, and now, Russia’s invasion of Ukraine.

The US Federal Reserve and the Bank of England have already taken action to curb inflation, raising interest rates earlier than the ECB.

The euro’s recent plunge to two-decade lows against the US dollar also complicated inflation pressures.

What is the impact of interest rates?

The ECB said that raising the deposit rate would strengthen “the anchoring of inflation expectations.”

The bank’s previous policy of negative deposit rates effectively penalizes banks for parking money with the ECB overnight. It was aimed to encourage more lending and, therefore, more economic activity, which can also contribute to inflation.

In turn, raising interest rates could help bring down inflation. But higher borrowing costs could also spell trouble for heavily indebted countries like Italy or Spain. To address this, the ECB also unveiled a tool to correct stress in bond markets for indebted eurozone members.

Dubbed the “Transmission Protection Instrument (TPI),” the targeted bond-buying scheme “can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area,” the ECB said.

Meanwhile, Berlin said the ECB’s move was in line with its plan to return to a constitutionally enshrined debt brake, which means Germany’s federal and state governments were not allowed to run a budget deficit of more than 0.35% of GDP.

“We are experiencing a new economic era,” German Finance Minister Christian Lindner said.

Eurozone under stress

The eurozone is facing economic pressure, with hopes of a strong post-pandemic recovery dashed by overstressed supply chains and threats to Europe’s energy supply.

For this reason, the ECB had hesitated to raise interest rates despite the rampant inflation.

The interest rate rise also comes as the national unity government in Italy, the second-most indebted eurozone state, seems on the point of collapse.

Investors are concerned about whether Italy is in a position to deal with increased borrowing costs amid the political turmoil.

On a more positive note, the euro currency is rising, partly on the back of news that Russian gas is flowing to Europe again through the Nord Stream 1 pipeline after a 10-day maintenance shutdown.