Tags: european economy | central bank | interest rate hike

Europe Likely to See Another Jumbo Interest Rate Increase

Europe Likely to See Another Jumbo Interest Rate Increase

Thursday, 27 October 2022 05:00 AM EDT

The European Central Bank is set to follow the playbook of the U.S. Federal Reserve in making its second big interest rate increase in a row on Thursday, underlining its determination to stamp out the record inflation that threatens to sink the 19-country euro area into recession.

An increase of three-quarters of a percentage point is the likely outcome of the meeting based on public comments from bank officials. The 25-member governing council led by bank President Christine Lagarde made the same record hike at its last meeting on Sept. 8, echoing drastic moves by the Fed, which hiked by three-quarters of a point for the third straight time last month.

The ECB is aiming to reduce inflation that hit 9.9% in September, the highest since statistics started being compiled in 1997 for the 19 countries that use the euro currency. That is far above its goal of 2% considered best for the economy.

A big increase would underscore the bank's resolve to get consumer prices under control but comes amid uncertainty about the future of the eurozone economy. Many economists are penciling in a recession for the end of this year and the first part of next year. While higher rates can fight inflation, they can also weigh on already slowing economic growth.

“The ECB has turned a blind eye on recession risks but is highly determined to bring down inflation and inflation expectations. To this end, it is hard to see how the ECB cannot move again” by three-quarters of a point, said Carsten Brzeski, chief eurozone economist at ING bank.

Analysts say another rate hike is likely at the ECB’s December meeting.

Bank policymakers had differing views about the strength of the economy at their last meeting, according to a written account released Oct. 6. There is high uncertainty about the course of the war in Ukraine, which sent energy prices sharply higher this year. That has raised utility bills, robbing consumers of purchasing power and making some factory work unprofitable, slowing the economy.

The ECB's interest rate decisions strongly influence borrowing costs for businesses and consumers. Making credit more expensive tends to slow purchases and investment, reducing demand for goods and services and, in theory, cooling inflation. Its key refinancing rate for loans to banks stands at 1.25%.

The bank also must keep an eye on the euro's sagging value against the U.S. dollar, although the ECB says it does not target any particular exchange rate. A weaker euro worsens inflation by raising the price of imported goods. The euro rose above parity with the dollar on Wednesday but remains near its lowest levels in 20 years.

Reasons for the dropping exchange rate include higher U.S. interest rates that attract money into investments priced in dollars and, more broadly, the dwindling prospects for Europe's economy. Europe is facing headwinds from the loss of cheap Russian natural gas and an economic slowdown in key trade partner China.

ECB rate hikes, other things being equal, could support the euro by lessening the interest rate gap with the U.S.

The bank also might sketch out ways to sop up the excess pandemic stimulus that has outlived its purpose now that rates are rising — and do it without triggering turmoil in nervous markets.

Part of that is the 4.9 trillion euros ($4.9 trillion) in bonds purchased as part of other stimulus efforts. For now, the ECB is maintaining the size of its bond pile by taking the money it gets from maturing bonds and buying new ones.

Shrinking the pile could roil bond markets and make government borrowing costs more expensive if not timed carefully because the ECB is such a large bondholder.

The risks of bond market trouble were illustrated when then-U.K. Prime Minister Liz Truss announced tax cuts and spending increases last month that raised questions about state finances, triggering a sudden selloff in British government bonds and sharply higher borrowing costs. The turmoil plunged the pound to record lows against the dollar, increased mortgage costs for millions of people and later forced Truss' resignation after 45 days in office.

The market ruckus underlined the hazards of unsettling bondholders already nervous about rising interest rates.

Bond markets are a potential trouble spot for the ECB, though they are relatively calm now. As rates go up, borrowing costs have risen for heavily indebted European governments, particularly Italy.

Rising borrowing costs threatened to break up the eurozone during its debt and banking crisis in 2010-2015. The ECB has outlined plans to backstop governments against borrowing costs seen as unjustified if need be.

The heads of the German and Dutch central banks have favored letting the bond pile run down from next year.

“Bond markets are highly volatile and nervous at present,” said Holger Schmieding, chief economist at Berenberg bank. He cautioned that “early reductions in bond holdings could exacerbate market tensions” and “could spark political controversies early on.”

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The European Central Bank is set to follow the playbook of the U.S. Federal Reserve in making its second big interest rate increase in a row on Thursday, underlining its determination to stamp out the record inflation that threatens to sink the 19-country euro area into...
european economy, central bank, interest rate hike
Thursday, 27 October 2022 05:00 AM
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