With the ECB’s decision to raise key interest rates in the euro area by 0.5 percent, negative interest rates for banks and savers are history. However, that does not mean that concerns about a euro crisis have completely disappeared.
The first step is far bolder than expected: At their last meeting in Amsterdam six weeks ago, ECB President Christine Lagarde and the Governing Council of the European Central Bank agreed to only moderately raise interest rates by 0.25 percent on July 21. Now they are making a rate hike that is twice as large and raising the three key interest rates by 0.5 percent each.
The ECB not only announced the first interest rate hike in eleven years – it also ended the period of negative interest rates in one fell swoop. A number of observers had actually not expected the latter until September. The ECB wants to step up its game and raise interest rates again. At the press conference, Lagarde deliberately left it open how strong this second step will be: “We will proceed step by step and evaluate the data month by month,” she said. Whether the September rate hike will be 0.25 percent or 0.5 percent will be decided by the ECB committee immediately before the September 8 meeting.
According to the head of the ECB, turning away from negative interest rates is not a historic step for her personally. She considers the introduction of the new TPI bond purchase program to be more memorable: “It is a historic moment, at least for me, that the entire ECB team, i.e. 25 committee members, decided in complete unity to introduce a new instrument, which we as critical in order to guarantee market stability. This is an encouraging moment,” stressed Lagarde. TPI is intended to prevent heavily indebted euro countries from getting into financing difficulties as a result of interest rate increases.
The assessment of many market observers has turned
During the course of this week, many market observers had already speculated as to whether the historic rate hike might not be higher than the previously envisaged target mark. Christine Lagarde herself had already indicated at the end of June that it could well be more than 0.25 percent. Because: “There are clearly conditions under which gradualism would not be appropriate.” The ECB now apparently sees this as a given. In the course of this week, central bank circles also leaked out that there could be a larger rate hike – the markets hardly reacted to it.
In fact, a clear signal against the ever-increasing inflation is urgently needed, which is now at 8.6 percent for all of Europe. In individual countries such as Estonia and Lithuania, the rate of inflation is already more than 20 percent, and in Germany it is also an impressive 8.2 percent. “And the risk that it will continue to increase and spread across the board is great,” Lagarde emphasized several times. That was the main reason for the ECB’s decision. Some economists expect price increases to reach the ten percent mark across Europe by September.
The trigger for the high price increases is mainly the Ukraine war, which has made energy enormously expensive and causes food prices to rise. But the interrupted supply chains in Asia as a permanent consequence of the corona pandemic are also contributing to the fact that raw materials, goods and consumer goods are constantly becoming more expensive. In addition, there is the “imported inflation” that is spilling over from America: because the US Federal Reserve has been in power for a long time, interest rates there are already considerably high at 1.5 to 1.75 percent. That is why the dollar is strong – and is now making imports of goods from the USA more expensive. And these factors will continue for a while.
That is why the assessment of many market observers had recently turned: in the spring, many analysts were still praising the ECB’s cautious course. It is said to prepare the financial markets well for this first interest rate hike. Gradually and without provoking shocks. Nobody could say in July that they were unable to foresee the turnaround in interest rates and therefore had to suddenly withdraw their money from certain securities. Overall, the ECB is under pressure, as many said a few weeks ago, but unlike the American Federal Reserve, it is facing the bow wave of inflation.
Italy is in a real government crisis
Only a few weeks later, the criticism became louder. The inflation rate of almost nine percent swept across the European continent, and the end of the price increases is far from in sight. Many currently consider the ECB to be driven because it has not acted before, instead delaying the first rate hike for so long. By the way, as one of the very few central banks worldwide, because more than 75 other central banks have already reacted to the high price phase.
The ECB probably hesitated for fear of triggering a new European debt crisis. Especially with regard to Italy. The southern European country has not only been struggling for a long time with a debt amounting to around 150 to 180 percent of its economic power (depending on how you calculate it), but is now also in a real government crisis.
Italy’s Prime Minister and Lagarde’s predecessor Mario Draghi has resigned. In the eyes of many financial market participants and EU politicians, it is one of the last guarantors of stability. If anyone could have stabilized the country economically and fiscally, it would be him. But now Italy is lurching towards new elections and no one knows how they will turn out.
This is why the ECB has been struggling so tenaciously to find the right course: between the need to raise interest rates and thus calm inflation, and the risk of stalling the economy and overburdening the debt sustainability of individual countries. It is harder for you to refinance at higher interest rates.
Controversial instruments versus spreads
With every week that has so far passed so inflation-driven in the country, people in this country got used to the phase of rising prices. Which means that inflation is self-reinforcing. Because the wage-price spiral is gradually getting underway, when workers everywhere are demanding higher wages because of the higher prices and are getting them because employers don’t want to lose even more skilled workers. However, this comes at the cost of companies passing on the higher labor costs to prices, which push them up even further. It is precisely this upward trend that the ECB must now stop with higher interest rates, because otherwise it will become more difficult every day.
On Thursday, however, the market was even more excited about the plans for the “Transmission Protection Instrument” (TPI), about which there had already been much speculation. With this so-called anti-fragmentation instrument, the ECB wants to prevent the interest rate hikes from having too much of an impact on the yields on government bonds and thus getting Italy in trouble. The ECB wants to avoid the euro zone falling apart into weaker countries with high bond spreads and stronger countries with small spreads.
Under certain conditions, it wants to buy up government bonds from high-interest countries and reinvest expiring funds so that the securities are not bought up on the open market by speculators who want to bet against the solvency of such countries. Namely, if there is an immediate risk that there would otherwise be severe market distortions in the entire European financial market, Lagarde justified the introduction of the TPI. In an emergency, the instrument was expressly “intended as a protective shield for all euro countries”.
The extent to which purchases under the TPI take place depends on the severity of the risks to monetary policy transmission, the central bank said. However, according to Lagarde, it is clear that “the ECB is able and large enough” for such interventions, “there is no ex-ante limit for the program.” This is reminiscent of Draghi’s famous “whatever it takes”. However, the extent to which the ECB is still within its legal framework with the TPI, or whether this does not already fall under the impermissible financing of individual states, is highly controversial.
markets restless
Ifo boss Clemens Fuest, for example, warns: “There is a risk that the ECB will cross the line of state financing, jeopardize its independence and set the wrong incentives for financial and economic policy.” The ZEW economist Friedrich Heinemann takes a similar view: “The ECB is thus increasingly becoming the authority that decides on the ability to finance high national debts and thus also on the fate of governments,” he said after the decision. “That is not compatible with the monetary policy task of an independent central bank.”
Market observers initially reacted positively to the sharp increase in interest rates: “It’s good that the Governing Council of the ECB has decided to take a big interest rate hike,” said ZEW economist Heinemann. Immediately after the decision, ING Bank announced that it would now abolish the penalty interest for all customers. In addition, it wants to offer existing customers up to 1.5 percent interest in the future and will introduce a savings bond with terms of between one and five years from August 1st. “Today’s ECB decision shows where the interest rate trip is going,” said ING Germany boss Nick Jue.
According to Deka chief economist Ulrich Kater, it’s good that the ECB now sees itself as a hawk and an inflation fighter, “because the responsibility for inflation lies exclusively with the central bank and nobody else.” The end of negative interest rates is also the end of “monetary cockaigne”. On the stock exchanges, the vote was not quite as clear. The Dax initially fluctuated heavily and lost significantly after rising in the afternoon. At times it was just over 13,100 points. MDax and Eurostoxx reacted similarly. Italian government bonds initially also fell sharply.
This text is first at Capital.de appeared.