ECB planning big interest rate increase to rein in soaring inflation, economists say

Prices in August climbed 9.1 per cent from a year ago — nearly five times the central bank's 2 per cent target for the medium term

The ECB appears poised to join more than 40 central banks that have used big rate increases to curb inflation. AFP

The European Central Bank is on the brink of a three-quarter-point increase in interest rates to wrest back control over record inflation, even as the risk of a eurozone recession rises.

The monetary-tightening step, which would lift the deposit rate to 0.75 per cent from 0 per cent, is predicted by a majority of economists surveyed by Bloomberg, including Wall Street heavyweights Goldman Sachs, Bank of America and JPMorgan Chase.

Investor bets also lean towards 75 basis points, although it is not a done deal. Wagers have retreated partially in recent days as weak economic data stoke fears of a downturn and doves who fret about the growth outlook rallied behind a more modest half-point increase.

A bigger move would mean the ECB joins the more than 40 central banks, including the US Federal Reserve, that have used significant rate increases to curb stubborn inflation.

It could also perk up a flagging euro and send a strong message to critics who say policy makers were too slow to act as the end of Covid lockdowns and the war in Ukraine sent prices soaring.

The rate decision is expected later today ahead of bank president Christine Lagarde’s news conference, with updated economic projections due alongside the announcement.

Investors are also eager for clarity on how rising borrowing costs will affect the ECB’s treatment of the €4.5 trillion ($4.4tn) of excess liquidity sloshing around Europe’s financial system, and for a steer on when officials may begin shrinking the stash of bonds they accumulated during recent crises.

The prospect of a three-quarter-point rate increase emerged late last month from Governing Council hawks attending the Fed’s annual Jackson Hole retreat. Even some of their warier colleagues urged forceful action.

Whether it materialises will depend in part on the new forecasts — specifically, how much the growth and inflation outlooks have worsened, with some analysts saying the 19-member currency bloc is already in a recession.

Prices climbed 9.1 per cent from a year ago in August — nearly five times the ECB’s 2 per cent target for the medium term — while a measure excluding food and energy also hit an all-time high. Consumers surveyed by the ECB predict inflation of 5 per cent over the next 12 months and 3 per cent in three years’ time.

The euro has not helped. Its slump to below parity against the dollar has raised the cost of imports, particularly commodities priced in the US currency. Anything less than a three-quarter-point raise risks further weakness, according to Societe Generale’s Anatoli Annenkov.

ECB hawks will face opposition from chief economist Philip Lane, who has proposed a “multi-step calibrated series rather than a smaller number of larger rate increases".

There are signs of political discomfort too. Spanish Prime Minister Pedro Sanchez said this week that monetary tightening “must be made compatible with an economic recovery path”.

With the deposit rate about to exceed zero for the first time in more than a decade, the ECB may also adjust the way it remunerates trillions of euros of excess liquidity held by commercial lenders in its accounts.

That money created income for the ECB while the deposit rate was negative, but the process will reverse when the latest rate increase takes effect next Wednesday.

Since the ECB said in July that it will “evaluate options” on remunerating excess liquidity, policy makers including France’s Francois Villeroy de Galhau have pushed for a swift solution.

The concern is that commercial lenders will receive sizable risk-free income while national central banks will incur losses — a situation that could impede the effective transmission of the ECB’s monetary policy.

Announcing changes on Thursday could prompt banks to increase early repayments of long-term loans this month. Knowns as TLTROs, they’ve created almost half the region’s excess liquidity.

Offloading the almost €5tn of bonds the ECB bought during recent crises is seen as the logical next step in removing stimulus.

Policy makers have signalled that they are in no particular rush to follow the Fed and the Bank of England in proceeding with so-called quantitative tightening.

But more hawkish officials, including Latvian central bank governor Martins Kazaks, have said the issue should at least be discussed relatively soon.

The ECB’s efforts are complicated by concerns that national bond markets will react differently to quantitative tightening, threatening to widen the spread between the German yields and those of more indebted member states.

For Italy’s 10-year notes, that gap was about 235 bps on Wednesday, near this year’s high.

Quantitative tightening, when it begins, will probably focus on reducing the €3.3tn of holdings accumulated under a 2015 programme designed to avert deflation.