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Economy

European Central Bank Set to Join US Fed in Jumbo Rate Hikes

September 8, 2022

FRANKFURT, Germany — The European Central Bank is set to join the U.S. Federal Reserve in making a jumbo interest rate hike Thursday as it tries to stamp out record inflation — although it risks worsening a recession that economists say is bearing down on Europe.

The meeting of the bank’s governing council is not about whether to raise its main benchmark for the 19 countries that use the euro currency, but by how much: between half a percentage point or an unprecedented three-quarters of a point, analysts say. The bank made its first increase in 11 years at its last meeting in July, raising rates by a half-point when it usually changes by only a quarter-point.

The ECB, which once predicted no rate increases at all this year, has torn up its road map in the face of record inflation of 9.1% last month, which has been driven by skyrocketing prices for natural gas and lasted much longer than expected. Inflation is far above the bank’s goal of 2% considered healthiest for the economy.

The central bank’s rationale for an increase of three-quarters of a point would be that “failing to act today would lead to larger moves and higher costs in the future,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.

The price of natural gas — used to generate electricity, heat homes and run factories — has jumped more than tenfold as Russia has throttled back deliveries as tensions mount over the war in Ukraine. European politicians call it blackmail over their support for Kyiv.

The resulting inflation is making everything from groceries to utility bills more expensive, creating a cost-of-living crisis that will only worsen as many economists predict the eurozone sinking into recession at the end of this year and into 2023.

At her last news conference in July, ECB President Christine Lagarde said that under the bank’s baseline economic forecast, “there is no recession, neither this year nor next year. Is the horizon clouded? Of course it is.”

Raising interest rates is the typical central bank antidote for higher inflation. Higher rates influence the cost of credit throughout the economy, making it more expensive to borrow, consume and invest, thus dampening the demand for goods. The problem is that inflation is not coming so much from demand, but from the supply side of the economy — oil and natural gas costs — which the ECB can do little about directly.

The ECB is behind other central banks in raising interest rates, and analysts say it is now concerned its credibility as an inflation-fighter is at stake, opening the possibility that rates will go up faster than expected even a few weeks go.

Its benchmark is 0.5% for lending to banks. The Fed’s main benchmark is 2.25% to 2.50% after several large rate hikes, including two of three-quarters of a point. The Bank of England’s key benchmark is 1.75%.

A top ECB official, Isabel Schnabel, said last month that “determination” was better than “caution” which threatens to allow inflation to get baked into people’s expectations for prices and wages. That’s when it would be much harder to control.

Decisive action now offered the chance to snuff out excess inflation “even at the risk of lower growth and higher unemployment,” Schnabel, a member of the six-member executive board that runs the bank day to day, said Aug. 27 at a Federal Reserve symposium in Jackson Hole, Wyoming.

Price stability is the bank’s primary mandate under the European Union treaty.

The ECB’s action would come “even at the cost of inflicting further short-term pain on households, workers and companies,” said Holger Schmieding, chief economist at Berenberg bank. “However, the ECB has a good reason to be more aggressive.”

Otherwise, bringing down ingrained inflation “in the future could be even more costly,” he said.

Higher interest rates would help support the euro’s exchange rate against the dollar by increasing demand for euro-denominated investment holdings. The euro’s recent slide to under $1 — driven by soaring energy costs and dampening economic prospects — raises inflation because it makes imported goods more expensive.

Some think the central bank is overreacting.

“There is a major risk that this determined approach by the ECB will not only lead to lower growth and employment than now, but lower than needed to tame inflation,” wrote Erik F. Nielsen, group chief economics adviser at UniCredit Bank.

“Increasing concern about their reputation” could lead the ECB — and possibly the Fed as well — to overdo the monetary tightening, he added.

“We still find it hard to see how aggressive rate hikes can bring headline inflation down in the eurozone,” said Carsten Brzeski, chief eurozone economist at ING bank. “The economy is far from overheating and will almost inevitably fall into a winter recession, even without further rate hikes.”

 

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