The European Central Bank is slowing rate hikes but expects a protracted battle against inflation

The headquarters of the European Central Bank (ECB) in Frankfurt

Written by Francesco Canepa and Palazz Corani

FRANKFURT (Reuters) – The European Central Bank decided on Thursday to slow the pace of interest rate hikes, but stressed that policy tightening would need to be prolonged and said it would start in March to reduce liquidity provided to the financial system. An additional weapon in its fight against inflation.

Having taken the wrong stance on rising rates, the European Central Bank in July began raising interest rates at a rate unprecedented in its history. But, following in the footsteps of the US Federal Reserve and the Bank of England, among others, it chose to limit its rise to half a percentage point this month, compared to three-quarters of a point in September and October.

Thus, the deposit rate, which is the rate at which it rewards bank deposits with it, which was still negative in the spring, has increased from 1.5% to 2%, as expected by the markets.

Like the Fed and the Bank of England, the European Central Bank has clearly hinted that more increases are needed before inflation drops permanently. Its new economic outlook really does show that higher prices in the Eurozone may remain above its 2% target through 2025.

“We think interest rates will continue to have to rise substantially and at a steady pace,” Christine Lagarde, the company’s president, said at a news conference, adding that interest rates were expected to be raised by half a point “for an extended period of time.” .

He added, “Based on the information we have today, this presages another 50 basis point interest rate hike at our next meeting, possibly at the next meeting and possibly after that.”

Money markets are instantly priced into this scenario and are now banking on the deposit rate peaking at just over 3% by July, from 2.75% before the meeting.

However, Christine Lagarde’s remarks surprised some observers, who see it as contradicting the ECB’s rhetoric that its decisions will be taken “meeting by meeting” according to available data.

“There is a fundamental paradox there that words are not enough to solve,” said Francesco Papadilla, a former senior official at the European Central Bank and now a member of the Bruegel European think tank.

Christine Lagarde explained that risks to the inflation outlook remain to the upside, citing the possibility of stronger-than-expected wage growth and the possibility of seeing budgetary measures to support purchasing power taken by many countries to boost demand.

The press release published after the Governing Council meeting raises the possibility of a “short and weak” recession and Christine Lagarde noted that unemployment has returned to a historically low level.

A stronger-than-expected tone, which is driving the EUR higher

The more aggressive than expected tone of the council’s statement and press conference allowed the euro to rise above $1.07 for the first time since June.

In the bond market, the yield on German 10-year government bonds exceeded 2.08%, up more than 15 basis points on the day, European stocks extended losses mid-afternoon, and the Euro Stoxx 50 index yielded 3.37%.

“Unlike the US, there is still no clear sign of declining inflation in the eurozone, which could encourage the Governing Council to continue raising interest rates in 2023 for longer than the Fed. It is a supportive factor for the euro,” said Matthew Ryan, head of strategy. Market in Iberia.

The next step in the ECB’s monetary policy tightening will be to shrink the bond portfolio of about €5,000 billion that has accumulated in recent years on account of the ECB’s purchases in the markets to ensure interest rates are kept very low.

Starting in March, the APP purchase program portfolio is supposed to start shrinking at a “calculated and predictable pace”.

“This reduction will be 15 billion euros per month on average until the end of the second quarter of 2023, then its pace will be adjusted over time” from July, the press release specifies.

This process, which will amount to withdrawing liquidity from the financial system and aims to promote higher long-term interest rates, has already been initiated by the Federal Reserve and the Bank of England. In particular, it will have consequences for the financing costs of banks in the eurozone, and thus for interest rates for loans to businesses and households.

The impact of these announcements was immediate on government bond yields for countries considered the most fragile in the eurozone, such as Italy, which has long benefited from ECB purchases: the yield on 10-year notes issued by Rome rose more than 25 points to 4.119. %, and was heading for the largest one-session increase since March 2020, at the start of the COVID-19 crisis.

(Reporting by Balaz Courani; French version by Marc Angrand; Editing by Blandine Henault and Sophie Lewitt)