The European Central Bank raised its key interest rates by an unprecedented 75 basis points on Thursday and signalled further increases, prioritising the fight against inflation even as the bloc's economy seems to be heading towards a winter recession.
With inflation at a half-century high and approaching double-digit territory, policymakers are worried that rapid price growth could become entrenched, eroding the value of household savings and setting off a hard-to-break wage-price spiral.
Following up on its July rate increase, the ECB raised its deposit rate to 0.75 per cent from zero and lifted its main refinancing rate to 1.25 per cent, their highest levels since 2011, with further moves anticipated in October and December.
“Price pressures have continued to strengthen and broaden across the economy and inflation may rise further in the near term,” the ECB said in a statement.
“This major step front-loads the transition from the prevailing highly accommodative level of policy rates towards levels that will ensure the timely return of inflation to the ECB’s 2 per cent medium-term target,” it said.
Policymakers had for weeks oscillated between a 50 and 75 basis-point increase, but another jump in both headline and underlying inflation appears to have settled the debate as figures indicate that price growth is now seeping into the broader economy, making it even harder to dislodge.
Indeed, the ECB raised its inflation projections once again, lifting the 2023 outlook to 5.5 per cent from 3.5 per cent, and the 2024 forecast rate at 2.3 per cent, above its 2 per cent target.
Markets were little surprised, however, as investors had already priced more than an 80 per cent likelihood of a 75-basis-point move, even though economists polled by Reuters were more evenly split, showing only a slight majority expecting the larger move.
Despite the front-loading, further rate increases are likely, the ECB said.
“Over the next several meetings the Governing Council expects to raise interest rates further to dampen demand and guard against the risk of a persistent upwards shift in inflation expectations,” the ECB added.
Going into the meeting, conservatives feared that anything other than an outsized move would signal that the ECB was not serious about its inflation-fighting mandate — officially its sole objective.
That risked pushing up already high long-term inflation expectations, they said, which would signal a loss of confidence in the ECB and raise questions about the bank's inflation-targeting framework.
Timid action also risked weakening the euro and boosting inflation further through more expensive energy imports.
The euro has been languishing around parity against the dollar for weeks, not far from a two-decade low hit earlier this month.
That means more expensive imports of everything from oil to cars, which then raises prices for consumers.
Policymakers have also made the case for front-loading rate increases, partly to send a strong signal about the central bank's inflation-fighting commitment and partly to get most of them done before the onset of a recession becomes evident.
With high energy prices sapping purchasing power, a downturn is essentially inevitable. However, monetary policy is mostly powerless against a supply-shock driven downturn, firming the argument for increases even if the economy suffers.
Some policymakers are now openly talking about a recession, and the ECB's new projections also show sharply lower growth in the coming years.
Still, a shallow recession may be useful, some argue, as the bloc's labour market is increasingly tight and a downturn could provide relief to companies now struggling to recruit workers.
The bank sees the euro zone economy expanding by 3.1 per cent this year and 0.9 per cent in 2023. While this year's growth projection was lifted a touch, it was lowered sharply for 2023.