ECB surprises with aggressive key interest rate hike, first since 2011

The European Central Bank (ECB) raised interest rates on Thursday for the first time in 11 years by a larger-than-expected amount, joining steps already taken by the US Federal Reserve and other major central banks to target stubbornly high inflation.

The move raises new questions about whether the rush to make credit more expensive will plunge major economies into recession at the price of fighting inflation, which is forcing people to spend more on food, fuel and everything in between.

The ECB’s surprise hike of half a percentage point for the 19 countries using the euro currency is expected to be followed by another increase in September, possibly of another half-point. Bank President Christine Lagarde had indicated a quarter-point hike last month, when inflation hit a record 8.6%.

She said the bigger hike was unanimous as “inflation continues to be undesirably high and is expected to remain above our target for some time.” As the bank leaves an era of negative interest rates, Lagarde said economic forecasts don’t point to a recession this year or next but she acknowledged the uncertainty ahead.

“Economic activity is slowing. Russia’s unjustified aggression towards Ukraine is an ongoing drag on growth,” the ECB chief said at a news conference. Higher inflation, supply constraints and uncertainty “are significantly clouding the outlook for the second half of 2022 and beyond.”

The ECB is coming late to its rate liftoff - a token of inflation that turned out to be higher and more stubborn than first expected and of the shakier state of an economy heavily exposed to the war in Ukraine and a dependence on Russian oil and natural gas. Recession predictions have increased for later this year and next year as soaring bills for electricity, fuel and gas deal a blow to businesses and people’s spending power.

The ECB made the bigger-than-expected increase to underline its determination to get inflation under control after its late start, said Carsten Brzeski, chief eurozone economist at ING bank. The move aims “to restore the ECB’s damaged reputation and credibility as an inflation fighter.”

“Today’s decision shows that the ECB is more concerned about this credibility than about being predictable,” Brzeski said.

Recession concerns have helped push the euro to a 20-year low against the dollar, which adds to the ECB’s task by worsening energy prices that are driving inflation. That is because oil is priced in dollars.

Raising rates is seen as the standard cure for excessive inflation. The ECB’s benchmarks affect how much it costs banks to borrow - and so help determine what they charge to lend.

But by making credit harder to get, rate increases can slow economic growth, a major conundrum for the ECB as well as for the Federal Reserve. The Fed raised rates by an outsized three-quarters of a point in June and could do so again at its next meeting. The Bank of England started the march higher in December, and even Switzerland’s central bank surprised with its first increase in nearly 15 years last month.

The goal for all central banks is to get inflation back down to acceptable levels - for the ECB, it’s 2% annually - without tipping the economy into recession. It’s difficult to get right as central banks reverse what has been a decade of very low rates and inflation. “The most precious good that we can deliver and that we have to deliver is price stability. So we have to bring inflation down to 2% in the medium term. That is the imperative,” Lagarde said. “And it’s time to deliver.”

Yet the European economy has the added worry of a potential cutoff of Russian natural gas, which is used to generate electricity, heat homes and fuel energy-intensive industries such as steel, glassmaking and agriculture. Even without a total cutoff, Russia has steadily dialed back gas flows, with EU leaders accusing the Kremlin of using gas to pressure countries over sanctions and support for Ukraine. Rising interest rates follow the end of the bank’s 1.7 trillion-euro (dollar) stimulus program that helped keep longer-term borrowing costs low for governments and companies as they weathered the pandemic recession.

Those bond-market borrowing rates are now rising again, especially for more indebted eurozone countries such as Italy, where Premier Mario Draghi’s resignation has brought back bad memories of Europe’s debt crisis a decade ago. Markets fear the exit of the former ECB president, who has pushed policies meant to keep debt manageable and boost growth in Europe’s third-largest economy, could raise the risk of another eurozone crisis.

The bank approved a new financial backstop that is part of its arsenal to prevent that from happening again. The ECB would step into markets to buy the bonds of countries facing excessive and unjustified borrowing rates. But it wouldn’t offer protection if the ECB determines higher borrowing costs resulted from poor government decisions.

Buying bonds drives their price up and their yield down, because price and yield move in opposite directions, thus capping interest costs. Spiraling bond-market rates threatened to break up the euro in 2010-2012 and led Greece and countries to turn to other members and the International Monetary Fund for bailouts.