The European Central Bank is set to hike interest rates for the first time in over a decade on Thursday as fears of gas supply cuts cloud the outlook for the euro-zone economy.
With inflation rising, central bank policymakers have committed to raising interest rates by at least a quarter point from their current historical lows.
Consumer prices rose 8.6 percent annually in June, a record for the euro zone and well above the ECB’s 2 percent target.
The disrupted supply chains and rising energy costs following the Russian invasion of Ukraine, which have fueled price hikes, are also weighing on economic activity in Europe.
The continent’s reliance on Russian energy imports has eurozone members bracing for a difficult winter and planning to ration supplies if Moscow cuts gas supplies.
The European Commission on Wednesday presented a plan to cut gas consumption by 15 percent to mitigate the worst potential impact on the economy.
But with inflation showing no signs of slowing, the ECB lagging behind its peers in the UK and US, and the euro looking weak against the dollar, the ECB is under pressure to consider bigger rate hikes.
– giant steps –
Central banks would normally be reluctant to raise rates with the economy in such a precarious position, “but inflationary pressures have risen to the point that whatever breaks the ECB has to act,” said Frederik Ducrozet, head of macroeconomics Research at Pictet Wealth Management.
Finding a way to balance growth and inflation risks seems like “an impossible equation to solve” for the ECB, he said.
The central bank’s deposit rate has been negative for eight years, and the key interest rate is currently minus 0.5 percent.
The penalty rate, which effectively forces banks to park their money overnight at the ECB, should encourage more lending, more economic activity and higher inflation rates.
ECB President Christine Lagarde said the aim was to move interest rates out of negative territory as part of a “gradual but sustained” series of rate hikes by the end of September.
Meanwhile, the US Federal Reserve and Bank of England have already jumped ahead of the ECB by starting their rate-hike cycles earlier and raising rates more aggressively.
It’s hard to explain why the ECB “would spend the summer on negative interest rates while eurozone inflation continues to rise,” said Franck Dixmier, head of fixed income at Allianz Global Investors.
– transmission lost –
The last time the ECB raised interest rates was in 2011, the emergence of a European debt crisis quickly forced the central bank to change course.
The ECB President who finally calmed tensions in the bond market was Mario Draghi, who is now Prime Minister of Italy and is at the center of fresh sovereign debt concerns as his coalition teeters on the brink.
The ECB’s announcement in early June that it was finally raising interest rates meant that borrowing costs for more indebted eurozone members like Italy rose faster than others.
Limiting divergence between the 19 different members is “crucial” to ensure monetary policy moves are felt evenly across the eurozone, ECB Vice President Luis de Guindos said in early July.
To this end, the ECB has announced that it will “flexibly” reinvest maturing bonds from its portfolio to absorb debt from more vulnerable countries and ease the pressure.
The bank has also set about developing a new crisis tool to maintain the “carryover” of its monetary policy moves with targeted asset purchases.
ECB policymakers could reveal more details about the “anti-fragmentation” tool on Thursday, but the idea was met with skepticism by some ECB Governing Council members, who would see it only used under strict conditions.
At the same time, a political crisis in Italy is a “textbook case of a situation where the ECB should not intervene,” said Pictet’s Ducrozet.
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