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ECB raises rates for first time in more than a decade

Updates Finance by Updates Finance
July 21, 2022
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The European Central Bank has raised interest rates by half a percentage point — its first increase for more than a decade — while pledging to prevent rising borrowing costs from sparking a eurozone debt crisis amid political turmoil in Italy.

The ECB said in a press release after its governing council met in Frankfurt that it “judged that it is appropriate to take a larger first step on its policy rate normalisation path than signalled at its previous meeting” because of higher than expected inflation and the support of its new bond-buying scheme. The central bank had said last month that it would raise rates by a quarter point.

The euro gained more than 0.6 per cent against the dollar to rise to above $1.02. Concerns over global growth and inflation pushed the common currency to below parity last week.

Eurozone government debt sold off. The yield on Germany’s 10-year Bund, a proxy for borrowing costs across the eurozone, rose sharply after the announcement, adding 0.1 percentage points. The rate rise and the unravelling of Mario Draghi’s national unity coalition earlier on Thursday sent the yield on Italy’s 10-year bond up 0.24 percentage points to 3.6 per cent.

Its governing council said it would “safeguard the smooth transmission of its monetary policy stance” under a new programme set up to tackle any increase in the bond yields of individual countries beyond the level justified by economic fundamentals.

The new bond-buying programme would have no upper limit on purchases and “can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area”, it said. More details of the new “transmission protection instrument” (TPI) would come in a separate announcement at 2.45pm Frankfurt time.

The central bank’s deposit rate will rise from minus 0.5 per cent to zero, while the rate on its main refinancing operations will rise from zero to 0.5 per cent and its marginal lending facility will increase from 0.25 per cent to 0.75 per cent. The last time it raised rates by half a percentage point was in June 2002, a few years after the euro’s launch.

The central bank said rates would rise further in future meetings, adding: “The front-loading today of the exit from negative interest rates allows the governing council to make a transition to a meeting-by-meeting approach to interest rate decisions.”

The move is the first step in reversing a decade of ultra-easy monetary policy at the ECB, which has maintained a negative deposit rate and bought almost €5tn of bonds to support the economy over the past eight years. It is tightening policy in an effort to tackle record eurozone inflation of 8.6 per cent.

There are growing fears that higher interest rates will tip the eurozone into recession. The bloc has already been hit by soaring energy and food prices following Russia’s invasion of Ukraine, a slowdown in business activity and a drop in consumer confidence to record lows.

The ECB decision came hours after Draghi resigned as Italy’s prime minister. His planned exit is expected to trigger early elections this year.

Krishna Guha, head of policy and central bank strategy at US investment bank Evercore, said: “The combination of a brewing giant stagflationary shock from weaponised Russian natural gas and a political crisis in Italy is about as close to a perfect storm as can be imagined for the ECB.”

The political turmoil in Rome has raised concerns about how rising interest rates will affect the sustainability of Italy’s swollen public debts, which are higher than most eurozone countries at 150 per cent of gross domestic product.

Officials in more frugal countries such as Germany and the Netherlands worry that the ECB’s new bond-buying tool will encourage fiscal profligacy among member states and stray into “monetary financing” of governments — the printing of money by a central bank to prop up a country’s budget — which is against the EU treaty.

But the ECB believes its new instrument is justified because it will ensure its monetary policy is transmitted evenly across the bloc. It said: “By safeguarding the transmission mechanism, the TPI will allow the governing council to more effectively deliver on its price stability mandate”.

The 50 basis point increase in the ECB’s main policy rates went beyond its guidance last month that it intended to start raising rates by 25 basis points and exceeded most economists’ expectations despite leaks this week that it was considering a larger move.

Central banks are typically reluctant to break their guidance, as this risks eroding their credibility. But the ECB has been under intense pressure from critics accusing it of being behind the curve in tackling eurozone inflation, which hit an all-time high of 8.6 per cent in the year to June.

The ECB lacks experience of raising rates. The last time that it did so in 2011, under then president Jean-Claude Trichet, it was forced to reverse the move a few months later as the eurozone was gripped by a sovereign debt crisis. The only current member of its 25-person governing council who was there at the time of its last rate rise was Klaas Knot, who had taken over at the Dutch central bank seven days earlier.

The ECB has been slower than most central banks to respond to surging inflation and is lagging behind the US Federal Reserve, which is next week expected to raise rates by at least 75 basis points, matching a similar-sized move last month.



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