The European Central Bank raised interest rates by more than expected on Thursday, with the prospect of further rises on the cards.
The ECB raised its benchmark deposit rate by 50 basis points to zero per cent, breaking its own guidance for a 25-basis-point move as it joined other major central banks in raising borrowing costs. It was the euro zone central bank's first rate hike for 11 years.
The 0.5 percentage point increase for the 19 countries using the euro currency is expected to be followed by another increase in September, possibly of another half a point.
The bank said the larger than expected increase was justified by an “updated assessment of inflation risks.”
Ending an eight-year experiment with negative interest rates, the ECB also increased its main refinancing rate to 0.50 per cent and promised further rate hikes, possibly as soon as its next meeting on September 8.
Raising rates is seen as the standard cure for excessive inflation, running at 8.6 per cent in the eurozone in June, largely driven by soaring energy prices.
Economies in Europe have been 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.
“Further normalisation of interest rates will be appropriate,” the ECB said in a statement. “The front-loading today of the exit from negative interest rates allows the Governing Council to make a transition to a meeting-by-meeting approach to interest rate decisions.”
The ECB had for weeks guided markets to expect a 25-basis-point increase but recent indicators pointed to a further deterioration of the inflation outlook.
With inflation already approaching double-digit territory, it is now at risk of getting entrenched above the ECB's 2 per cent target and any gas shortage over the coming winter is likely to push prices even higher, perpetuating rapid price growth.
The euro, which fell to a two-decade low against the dollar earlier this month, firmed about 0.6 per cent on the ECB's decision.
The ECB also agreed to provide extra help to the 19-country currency bloc's more indebted nations, approving a new bond purchase scheme called Transmission Protection Instrument, intended to cap the rise in their borrowing costs and limit financial fragmentation.
“The scale of TPI purchases depends on the severity of the risks facing policy transmission,” the ECB said in a statement. “The TPI will ensure that the monetary policy stance is transmitted smoothly across all euro area countries.”
As ECB rates rise, borrowing costs increase disproportionately for countries such as Italy, Spain or Portugal as investors demand a bigger premium to hold their debt.
The ECB's commitment on Thursday comes as a political crisis in Italy is already weighing on markets following the resignation of Italy's prime minister Mario Draghi.
The ECB's 50-basis-point hike on Thursday still leaves it lagging its global peers, particularly the US Federal Reserve, which lifted rates by 75 basis points last month and is expected to move by a similar margin in July.
But the euro zone is more exposed to the war in Ukraine and a threatened cut-off in gas supplies from Russia could tip the bloc into recession, leaving policymakers with the dilemma of balancing growth and inflation considerations.
Confidence has already taken a hit from the war, and high raw materials prices are depleting purchasing power.
But the ECB's ultimate mandate is controlling inflation, and rapid price growth for too long could perpetuate the problem as firms automatically adjust prices.
“The economic outlook is worsening by the day,” said Carsten Brzeski, chief eurozone economist at ING bank. “At the same time, headline inflation is still increasing and in our view will only come down gradually towards the end of the year, if it comes down at all. In hindsight, the very gradual and cautious normalisation process the ECB started at the end of last year has simply been too slow and too late.”
Recession concerns have helped push the euro to a 20-year low against the dollar, which adds to the ECB’s inflation fighting task by worsening already high energy prices. That is because oil is priced in dollars.