ECB Doubles Its Key Interest Rate

ECB Doubles Its Key Interest Rate
Stéphane Renevier, CFA

over 1 year ago3 mins

What just happened?

As widely anticipated, the ECB announced a 0.75 percentage point rate hike on Thursday – doubling its key interest rate and pushing it to its highest level since 2009. This brings it closer to the level considered to have a “neutral” impact on the economy, which market participants estimate at around 2% by December.

The central bank also toughened its stance on risk-free profits for Europe’s financial sector. Thanks to a cheap loan program implemented during the crisis, financial institutions have been able to pocket a risk-free profit by parking cash received at a higher rate at the ECB. Now, Europe’s central bank has essentially brought the two interest rates more in line, reducing the banks’ controversial profit in the process.

The ECB didn’t mention anything about quantitative tightening, however, an anticipated move to slim down its balance sheet. We’ll just have to wait a bit more to know how it plans to shrink the roughly €5 trillion ($5 trillion) of securities amassed under various stimulus programs. They also avoided giving an update on the likely path of future hikes.

What does it mean?

The mix of slow growth and high inflation is getting really toxic. Like almost every other region, Europe is between a rock and a hard place: it’s facing an economic recession, but stubbornly high inflation is keeping governments and central banks from implementing pro-growth policies. The more the ECB is forced to hike rates into a recession, the deeper the recession is likely to be. But if it doesn’t hike, or if it’s seen as holding back on hikes, it risks more upside risks to inflation. In other words: as long as inflation remains high, there’s no easy outcome.

Political risk is likely to go up a notch. Politicians in the 27-member EU (most recently Italy’s PM Giorgia Meloni and France’s President Emmanuel Macron) have started to openly complain about rate hikes being unnecessarily aggressive. This will not just increase the pressure on the ECB’s next rate decisions, but also will increase the risks of fractures in the euro zone’s unity.

The risk of a financial accident is rising. Removing liquidity at a time when the economy is slowing sharply, liquidity conditions are poor, and a scarcity of high quality collateral (essentially German government bonds, or “bunds”) means that the risks of a “UK-style” financial accident are rising sharply.

The ECB is striking a less aggressive tone about the path of future rate hikes. The ECB made a key change to its statement – no longer saying “over the next several meetings the Governing Council expects to raise interest rates further", but instead softening the language, just slightly, saying it "expects to raise interest rates further”. Like the US Federal Reserve, it’s emphasizing the importance of data. With interest rates closer to 2% and growth falling sharply, this is likely to be interpreted as a dovish shift from market participants.

So, while today, the market might interpret this less aggressive tone from the ECB as a positive development for EU assets, it’s important to remember that political, financial, and macroeconomic risks keep on rising. Now more than ever, everything relies on what happens next with inflation…

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