The ECB Raises Interest Rates Back To Highest-Ever Level

The ECB Raises Interest Rates Back To Highest-Ever Level
Stéphane Renevier, CFA

7 months ago3 mins

What just happened?

In a move that most everyone saw coming, the European Central Bank (the ECB) hiked its deposit rate on Thursday, to a perky 3.75%, matching the all-time high set in April 2001. That’s the interest rate the ECB pays to banks for hanging onto their extra cash overnight.

At the same time, it lifted the main refinancing rate – the bill banks foot when they borrow money from the ECB – to a lofty 4.25%, the highest it's been since 2008.

A high deposit rate makes banks think twice about lending money out, since it's pretty sweet to just park all that cash at the ECB. A high refinancing rate, meanwhile, makes borrowing pricier. All this can put a dampener on economic activity. And, frankly, that’s the idea: by putting the brakes on the credit creation machine, the central bank hopes to slow the economy enough to bring inflation back in check.

That’s why, seemingly just for good measure, the ECB also decided to stop paying banks for the money they are required to keep at the institution as a minimum reserve.

Europe’s central bank has been throwing everything but the kitchen sink at the bloc’s stubbornly high inflation. This was the ninth-straight interest rate hike in a year, for a hefty combined total rise of 4 percentage points.

What does it mean?

Europe's in a pickle, even compared to the US, and walking a trickier tightrope between inflation and growth. The eurozone's economy is like a teetering game of Jenga: manufacturing's in the pits, especially in Germany, and high energy and borrowing costs have households and businesses wobbling. But, on the other hand, the service sector's still popping and the labor market has remained surprisingly resilient. This means the economy is swaying, but not enough to bring inflation down to the ECB’s preferred levels.

In fact, while headline (or all-items) inflation has halved from its peak, most of that’s been because of a fall in gas prices, not the ECB’s steering. More worrying is the fact that core inflation (which excludes the more volatile food and energy prices) isn't letting up on the heat, clocking in at a spicy 5.5% – more than double the ECB's 2% target. And fueling the whole swelter is a robust services sector that’s been amped up by record wage growth. So for the ECB’s policymakers, there’s very little choice: they’ve got to keep hitting the rate hike button, despite signs of a slowing economy.

So what’s next?

In terms of monetary policy, the ECB followed the Fed’s lead and made it clear that its next moves will depend strongly on upcoming data, giving policymakers the flexibility to pause or hike further. But zooming out, we're likely near the interest rate ceiling, with maybe a final 0.25 percentage point hike in September in the cards. Now, the ECB is likely to continue to talk tough and play tough with interest rate hikes, but investors are already speculating about when the central bank will start playing the rate-cutting game again, to respond to a weakening economy.

As for the economy, it’s likely headed for a slippery slope. The ECB's basically staring down a recession while pushing interest rates up and pump the brakes on growth. We're already seeing signs that those rate hikes are starting to bite, with eurozone companies' demand for loans hitting a record low in the second quarter of this year. This might just be the tip of the iceberg, given monetary policy's notorious lag time. So brace yourself, the economy might be in colder days ahead.

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