ECB gets hawkish on inflation with surprise 0.5% hike

The European Central Bank increased rates by 50bps at their July meeting today, to take the main refinancing rate from zero to 0.5%.  This is the first time they have increased rates since July 2011. Christine Lagarde, ECB president, and members of the Governing Council have been guiding markets to expect this first interest rate increase now, so its timing doesn’t come as a surprise, but markets’ central expectation had been for rates to only increase 0.25% at this juncture.

David Goebel, Associate Director of Investment Strategy at wealth manager Evelyn Partners, comments: Beginning their interest rate hiking cycle now, the ECB is behind the Bank of England and the US Federal Reserve, who began their hiking regimes in December 2021 and March 2022 respectively.  They have been criticised by some as being slow to act – and so increasing rates by more than expected indicates the ECB is keen to emphasise it is serious about inflation, which is running at an annualised clip of 8.6%.

Current inflation is very much a global phenomenon and is expected to fall away from current high levels in Europe (as with elsewhere) over the coming quarters.  Europe does have the added complication of proximity to the war in Ukraine, and the associated difficulties of reliance on Russian energy.  The Nordstream 1 pipeline reopened after maintenance today, and is running at 40% capacity, as it was prior to the work. While this is not ideal, allied with reasonable levels of gas in storage, it should be enough to see Germany and the rest of Europe through the winter.

Given prevailing levels of economic growth in Europe are rather lower than the US, it is a closer call as to whether the eurozone can avoid recession over the next year.  The base case of economic consensus remains that Europe does avoid a recession, sneaking through with a few quarters of anaemic growth.  Increasing interest rates and expectations for future rates shows the ECB is willing to tackle inflation, and developments with the TPI should console markets that they are also willing to act to avoid borrowing costs increasing too much for weaker economies.

Another thing stands out from the meeting – forward guidance. Before the meeting, markets had been expecting increases to accelerate from here, with 0.5% increases in September and possibly October too, before slowing down in 2023 to potentially peak around 2%. Today’s statement said that ‘further normalisation of interest rates will be appropriate’ and revealed a ‘transition to a meeting-by-meeting approach to interest rate decisions.’ This led to an increase in rate hike expectations for their next meeting, and higher expectations for rates thereafter.

Information on the Transmission Protection Instrument was light, and further detail is to follow in a separate release at 15:45 CET today.  The TPI is designed to stop eurozone peripheral spreads (e.g. Italian government bond yields) from increasing too much relative to lower borrowing costs within the bloc like that of Germany. The statement did say that ‘The scale of TPI purchases depends on the severity of the risks facing policy transmission’ which appeared to placate markets as peripheral spreads tightened.