The European Central Bank building, in Frankfurt, Germany, on July 21.WOLFGANG RATTAY/Reuters
The European Central Bank raised interest rates again on Thursday and put the reduction of its bloated balance sheet on the agenda, but said “substantial” progress had already been made in its bid to fight off a historic surge in inflation.
Worried that rapid price growth is becoming entrenched, the ECB is raising borrowing costs at the fastest pace on record. Further steps are almost certain as unwinding a decade’s worth of stimulus will take it well into next year and beyond.
The central bank for the 19 countries that use the euro raised its deposit rate by a further 75 basis points to 1.5 per cent – the highest rate since 2009. ECB rates had been negative – below 0 per cent – for eight years until it hiked in July.
It also cut a key subsidy to banks – an attempt to force them to repay early trillions of euros’ worth of ECB loans – and said detailed discussions on winding down the ECB’s huge holdings of mostly government bonds will begin in December.
While the bank dropped a reference in its policy statement to likely rate hikes at “several” more meetings, ECB President Christine Lagarde appeared to revert back to this terminology.
“We will have further rate increases in the future,” she told a news conference. “So it might well be several meetings.”
Markets nevertheless took Lagarde’s comments that a “substantial” part of policy tightening is done as a sign that rates may not go as high as previously thought.
Investors now see rates peaking at around 2.6 per cent next year, below expectations for close to 3 per cent, seen recently.
“We expect an additional 50 basis point policy rate hike in December, and a transition towards moving in 25 basis point increments next year as the hiking cycle pivots from policy normalization to policy tightening,” PIMCO portfolio manager Konstantin Veit said.
Lagarde argued that the ECB may have to “go beyond” normalization, a comment suggesting that rates may go to a level that starts restrictive economic activity.
While this neutral rate is an undefined concept, most policy-makers appear to put it at roughly 1.5-2 per cent, suggesting the ECB is now at the bottom end of the estimated range.
The euro dropped a touch on the ECB’s rate announcement, while bond yields dropped sharply and bank shares rose, reinforcing views that markets had been pricing in a more hawkish decision.
Lagarde also pushed back on political criticism that rapid rate hikes threatened to push the euro zone into recession, arguing that her job was to get inflation under control.
She acknowledged that the risk of an economic contraction was on the rise due to soaring energy prices and higher rates, but said it was up to governments to support their most vulnerable citizens through the crisis.
“Everyone has to do their job. Our job is price stability,” she said. “We have to do what we have to do. A central bank has to focus on its mandate.”
In reaction, German Finance Minister Christian Lindner welcomed the ECB’s determination to fight inflation while Italy’s new economy minister Giancarlo Giorgetti said the ECB needed to take the slowdown into account.
With euro zone inflation hitting 9.9 per cent, the ECB also took the first step toward shrinking its 8.8 trillion euro balance sheet, a move that is likely to raise borrowing costs further and may act as a sort of disguised rate hike.
In a move which may be fought by commercial banks, it curbed the subsidy it provides to such lenders through €2.1-trillion worth of ultracheap three-year loans called Targeted Longer-Term Refinancing Operations, or TLTROs.
The move will boost borrowing costs over the remaining lifetime of the facility, providing lenders an incentive to repay them early.
Having borrowed at zero or even negative rates at a time when the ECB’s main worry was persistently low inflation, banks can now simply park TLTRO cash with the ECB and enjoy a risk-free return that rises with each deposit rate hike.
This is politically contentious in itself, but an abundance of liquidity is also keeping money market rates depressed and preventing the ECB’s rate hikes from being fully passed through via the banks to businesses and households.
Banks will now have to pay a rate equalling the deposit rate or the ECB’s main refinancing rate from Nov. 23, depending on their lending performance. Both are above current market rates, which should encourage banks to repay the ECB.
Lagarde said the reduction of the ECB’s government bond holdings was not discussed, but that a – probably fractious – debate on that topic is likely to start soon.
Lagarde said policy-makers would discuss the “key principles” of how shrink the 3.3 trillion euro Asset Purchase Programme at their December policy meeting.