Today, the European Central Bank (ECB) raised its policy interest rate by 75 bps. This is the ECB’s third consecutive meeting delivering a policy rate hike, only the second occasion that it has raised by more than 50 bps in its history, and now brings the ECB policy rate to its highest level since 2009. The announcement impacts all three of its policy rate facilities: Main refinancing operations, the marginal lending facility, and the deposit facility. These will be increased to 2.00%, 2.25% and 1.50% respectively.

At the press conference, ECB President Lagarde stated that the ECB has “made substantial progress in withdrawing monetary policy accommodation,” suggesting that while more rate hikes are expected, the rate of such hikes could moderate.

The policy statement noted that the Governing Council “expects to raise interest rates further,” citing the necessity of doing so to achieve the central bank’s 2% medium-term inflation target. However, consistent with the “meeting-by-meeting approach,” President Lagarde was reluctant to guide around the specifics of any December rate decisions, but did state “we are not done yet,” and “more rate hikes are in the pipeline.” A slowing pace of tightening, both in terms of rate hikes and some deferral of liquidity withdrawal via balance sheet operations, was well-received by markets, which currently expect a 50 bps rate hike in December.

Balancing act

With eurozone annual headline CPI running at 9.9% in September, and rising nearly every month since July 2021, pressure continues for the ECB to arrest inflation and constrain demand. However, much of the inflation challenge in Europe derives more from the supply-side than from an excess of (a post- pandemic recovery in) demand. This is evident in the disparity between headline (9.9%) versus core (4.8%) inflation.

The ECB can still potentially impact two important components: Inflation expectations and wage growth. Consumer expectations of 12-month price pressures, having abated from the March record high, remain elevated and rose again in September. This contributes to hawkish justifications at the ECB, as inflation expectations increasingly threaten to become de-anchored. European wage inflation measures have been creeping up throughout the year, with Germany, France, the Netherlands, and Italy all experiencing annual wage inflation above 3%. By tightening monetary policy, the ECB is attempting to prevent higher inflation from becoming further entrenched in the European economy.

Yet, the ECB must manage a delicate tension between record high inflation amid a weakening outlook for economic growth. Eurozone PMI data has been deteriorating since April and entered contraction in July. Despite growing recession concerns, the ECB’s only policy rate option is continuing hikes to suppress inflation pressures.

APP preserved: No quantitative tightening yet

The Asset Purchase Programmes (APP) are one of the many balance sheet operations that the ECB has been deploying to support markets, and full reinvestment has been supported by its desire “to maintain ample liquidity conditions.” Today saw no change here, confirming the intention “to continue reinvesting, in full, the principal payments from maturing securities.” This was received by markets as an accommodative surprise.

TLTRO adjustment: Organic change

The ECB is adjusting the terms of its Targeted Long-term Refinancing Operations (TLTRO) loans, specifically the interest rates applicable to TLTRO III, and offering banks additional voluntary early repayment dates. This is intended to ultimately limit bank credit provision to the real economy, and incentivizes commercial banks to quickly repay their TLTROs.

Fragmentation risks

The Transmission Protection Instrument (TPI) was introduced earlier in 2022 to ensure that “the monetary policy stance is transmitted across all euro area countries.” In the event of elevated peripheral bond market yields and spreads becoming excessively wide, the ECB could institute bond purchases to cap peripheral bond yields. Despite some widening in September, which has recently abated, the TPI was not discussed by the ECB Council ahead of today’s meeting.

Discouraging outlook

With the European economy facing serious stagflationary challenges, as well as risks to energy security and war on its doorstep, the central bank has had the unenviable task of setting its monetary policies to navigate arduous times. Despite the depressed outlook for economic growth, raging inflation has nonetheless compelled the ECB to sharply hike rates yet again.

Despite aggressive rate hikes, the ECB is playing catch-up to the U.S. Federal Reserve, and with eurozone growth set to underperform the U.S., this has maintained downward pressure on the euro currency. Today’s policy decision failed to be supportive of the euro, which fell over 1.2% intra-day upon the policy statement release.

With today’s policy rate decision, the ECB will hope to curtail broadening inflation. Yet relief may only come with conflict de-escalation in Ukraine, a resolution to energy supply woes, and even perhaps a mild winter to relieve household energy bills and maintain consumer budgets—all very much wildcards, and thoroughly outside the directive of the ECB.


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