The European Central Bank (ECB) raised rates by 50 basis points (bps) at its July meeting, ending eight years of negative interest rates and bringing the deposit rate to zero. Triggered by rising inflation, this is the ECB’s first rate hike in more than a decade. The increase is more aggressive than what the market and consensus expected just a month ago when the ECB suggested that a significant increase would be “counterproductive.” Nevertheless, markets had already priced in a 50% chance of a 50-bps rise, which meant the impact to longer-term yields was somewhat tempered: the German 10-year bond yield only rose by a moderate 5 bps following the decision. Despite the unexpected 50-bps increase, interest rates remain low, and the ECB’s monetary policy is still relatively accommodative compared to other major central banks.
In June, the ECB hinted at a larger rate increase in September, if the inflation outlook did not look to be improving. This view has now somewhat changed: the ECB believes that by frontloading its actions in June, the governing council will be more able to respond to the data on a meeting-by-meeting basis. During the July meeting, the ECB also stated it will be limiting forward guidance due to its negative impact on the Bank’s credibility. As we move away from low rates, forward guidance is beginning to evolve1. Its prior role during the lower interest rate environment may now confine central banks, which is why we have seen a number of central banks now abandon their signalled plans of late.
The ECB faces more challenges
The ECB has been slower to raise rates than its counterparts. The Federal Open Market Committee raised rates by 200 bps so far this year, which included two consecutive 75 bps rate increases. Since December, the Bank of England (BoE) has delivered five consecutive rate hikes, totalling 115 bps, and is expected to proceed with another rate increase in August.
Unlike other central banks, the ECB is responsible for setting the monetary policy for 19 countries, and it is having to strike a balance between policy normalisation to tackle the rise in inflation — and its desire to prevent another debt crisis in Europe. The last time the ECB raised rates in 2011, it was forced to do a U-turn a few months later as the euro area plunged into a sovereign debt crisis.
10-year Government Bond Yields: Germany vs. Italy
In recent months, borrowing costs for highly indebted countries such as Italy (debt to GDP ratio increased to 160% during the pandemic from 105% in 2005) rose more sharply than in stronger economies like Germany (see chart above). The ECB hopes to address these market bifurcations in its new fragmentation tool—the Transmission Protection Instrument (TPI).
The TPI is designed to ensure changes in monetary policy are “transmitted smoothly” across the euro area. By purchasing government bonds of member states that experience a decline in financing conditions, the ECB will aim to prevent financial fragmentation. The TPI was unveiled as a tool with unlimited firepower, but it comes with its own “cumulative list of criteria” for eligibility External Link.
While the TPI is an additional tool at the ECB’s disposal, the Pandemic Emergency Purchase Programme (PEPP) will remain the first point of call to tackle transmission risks. The new tool was received with scepticism, as the TPI will only address the consequence (wider spreads) and not the cause, including differences in debt levels, growth prospects and competitiveness. The hope here is despite the complexities in deploying TPI, its introduction should help calm bond markets.
Why raise rates now?
The ECB spent a decade concerned about low inflation and now is faced with the problem of high inflation. As price pressures intensify, inflation continues to surprise on the upside with euro area inflation reaching a new high of 8.6% year-over-year (YoY) in June, up from 8.1% in May. Rising energy costs are the main factor driving inflation in the euro area. Energy price inflation in the euro area reached 41.9% YoY in June, despite many government interventions, accounting for more than half of the headline number. Energy remains a huge source of uncertainty, particularly as the euro area is highly exposed and vulnerable to the trade and production disruptions caused by the Russia-Ukraine conflict. Therefore, hiking interest rates will not bring the prices of energy down, instead, a resolution of the conflict and/or a solution to the supply chain disruptions would help.
Euro area Inflation Parsed
The ECB’s hike comes at a time when growth in the euro area is slowing. The preliminary Composite Purchasing Manager’s Index (PMI) for July—a forward-looking indicator of growth—fell to 49.4, a reading below 50 indicates a contraction. This is the lowest level since February 2021, when COVID-19 restrictions were still in place. It is widely expected that economic growth will slow in the second half of the year but remain positive. The ECB published its latest survey of professional forecasters, which included downward revisions to growth and upgrades to the inflation outlook. Economic growth of 2.8% is expected this year (down 0.1 percentage points from Q2 2022) and inflation is likely to average 7.3% in 2022. Whether this will ease the number of rate hikes for this year, only data will tell.
