The European Central Bank is finally taking up the fight against inflation with more courage. It hiked interest rates by a record 75 basis points. With this step, the danger of a recession increases.
Christine Lagarde wants to fight inflation with higher interest rates.
To combat record inflation, the European Central Bank (ECB) has decided to raise interest rates, the largest in its history. The key interest rate in the euro area will rise by 0.75 percentage points to 1.25 percent, as the ECB announced on Thursday. Last June, the monetary watchdogs raised interest rates for the first time in 11 years.
What is the starting position?
ECB boss Christine Lagarde reacted late. For a long time she had stuck to the extremely loose monetary policy with zero interest rates, as she considered the price increase to be temporary. Even as inflation soared, she continued to keep the reins of money loose. It even increased the money supply by having government bonds bought up.
It was only on July 21, far behind other central banks, that the ECB initiated the turnaround in interest rates – raising interest rates for the first time in eleven years. For more and more people, the record high inflation became a major burden. Higher inflation weakens people’s purchasing power. Central banks can counteract rising inflation rates with higher interest rates.
More than 40 central banks around the world have now taken up the fight against stubborn inflation with large interest rate hikes. The US Federal Reserve, for example, has already increased interest rates by 0.75 percentage points several times.
If the ECB decides to take a big step, this could support the currently very weak euro. In addition, the central bank would thus send a signal to the critics, who accuse it of reacting too laxly to the price increases that followed the end of the corona lockdowns and the war in Ukraine.
How high is the inflation?
Euro-area prices rose an unprecedented 9.1 percent year-on-year in August, and core inflation, which excludes food and energy, also hit a record high. And a further increase is likely. In principle, the ECB is aiming for a stable price level for the common currency area in the medium term with annual inflation of 2 percent. We’re a long way from that now.
“The longer inflation remains high, the greater the risk that the public will lose confidence in our determination and ability to maintain purchasing power,” ECB Executive Board member Isabel Schnabel warned in late August.
What is expected?
Experts expected interest rates to rise by at least 0.5 percentage points. The central bank had already announced such a move for today in July. The market was even betting on a record 75 basis point hike by ECB standards. Even a jumbo rate hike of a full percentage point was no longer ruled out.
Investors also awaited clarity on how rate hikes will affect the ECB’s handling of the €4.5 trillion in excess liquidity in Europe’s financial system. There was also the question of when the central bank would start reducing the mountain of bonds it had accumulated during the most recent crises.
What speaks against a giant step?
However, the monetary authorities are also concerned that the unstable economy could be slowed down by normalizing the ultra-loose monetary policy too quickly. Especially since the economy is already struggling with supply bottlenecks and the consequences of the Ukraine war, for example on the energy market. Some economists are of the opinion that the 19 euro countries are already in a recession.
The size of the rate hike therefore depended largely on how the ECB assesses future economic developments. It could also raise interest rates sharply, but offer the heavily indebted euro countries help through bond purchases.
How high are the key interest rates in the euro area at the moment?
The ECB ended the long phase of negative interest rates in July and increased the key interest rate in the euro area from 0 to 0.5 percent. The interest rate for the main refinancing operations has been 0.50 percent since then. The commercial banks receive money from the ECB at this interest rate.
To the delight of millions of savers, the Governing Council of the ECB ended the phase of the negative interest rate policy: since then, commercial banks no longer have to pay 0.5 percent interest when they park money with the central bank. This deposit rate is currently 0 percent.
How fast can a rate hike bring inflation down?
Even if the ECB is now raising interest rates sharply, inflation will not fall automatically and immediately. When the interest rate that banks have to pay to the central bank rises, they pass it on to their customers and raise interest rates if they want to borrow. This makes investing more expensive. This dampens demand and ultimately also prices. However, the effect needs at least several months before it becomes noticeable.
The inflation expectations of households and companies are particularly important for the price development. If they expect rising prices, employees demand higher wages, which in turn pushes up prices. There is a risk of a so-called wage-price spiral.
What are the implications of the ECB interest rate decision for savers?
The turnaround in interest rates brought savers the end of negative interest rates. Many banks are now paying low interest rates again. However, because the inflation rate has risen even more sharply, real interest rates remain very much in negative territory. If you receive 1 percent interest on your money with an inflation rate of 8 percent, you still lose 7 percent in money value and purchasing power in one year. This gap is likely to close very slowly.