The European Central Bank (ECB) has taken a bold step by raising interest rates to an unprecedented level, aiming to control consumer prices. This decision, reached during the governing council’s meeting in Frankfurt on Thursday, marked the 10th consecutive increase, with the deposit rate raised by 25 basis points to 4 percent. It’s worth noting that this move occurred simultaneously with officials revising their growth projections for the eurozone economy, indicating a challenging economic landscape.
Europe’s economy has seen weaker growth
The European Central Bank’s decision, the most significant in over a year, saw a divided council debating the course of action. While more dovish members pointed to indicators of weaker growth, including slowing bank lending, a cooling labor market, and falling inflation, hawks expressed concerns about persistently high inflation.
The US Federal Reserve and the Bank of England will hold meetings in the upcoming week. Many economists anticipate that major central banks are approaching the conclusion of their rate hikes, given the decline in inflation and the slowdown in economic growth due to elevated borrowing costs.
With Thursday’s decision, the ECB deposit rate surpasses the previous record high set in 2001, a move made to bolster the newly launched euro’s value. That underscores that policymakers are more concerned about the risk of sustained consumer price growth above target than the potential of a sharp economic downturn.
Recent economic data, including a decline in industrial production and retail sales in July and business surveys indicating a further downturn in August, led economists to lower their growth forecasts for the eurozone. Policymakers believe that this deceleration in economic activity will likely temper price pressures.
Eurozone inflation has already retreated from its peak of 10.6% last year to 5.3% in August. While inflation is expected to continue declining, it’s not expected to reach the ECB’s 2% target until 2025.
ECB President hints possible further rate hike
ECB President Christine Lagarde left the door open for a possible further rate hike, emphasizing that interest rates must stay at restrictive levels for a significant period. She noted that while the focus will shift towards the duration of the current policy, it’s premature to declare that they have reached the peak.
Lagarde acknowledged differing opinions among ECB board members regarding the recent rate hike but highlighted that most governors supported the decision.
Addressing concerns about the ECB’s revised growth projections, which now stand at a modest 0.7% for the euro area this year, Lagarde attributed the slowdown to temporary factors. She expressed confidence in an anticipated growth resurgence in 2024. The adjustment to the 2024 inflation forecast likely factored into deliberations as policymakers assessed the risk of inflation remaining elevated.
The ECB’s decision to raise the deposit rate by 25 basis points to 4.0% marks the highest level since the euro’s inception in 1999. Just over a year ago, this rate was at an all-time low of minus 0.5%, necessitating banks to pay to hold their funds at the central bank.
Money markets had anticipated the deposit rate to reach 4.0% before undergoing a reduction in the latter half of the following year, leading to this week’s meeting. In contrast, markets have completely factored in unchanged rates at the upcoming US Federal Reserve meeting. The Fed initiated its rate hikes earlier and has surpassed the ECB’s rate level.
However, the aggressive tightening cycle, twice as steep as the ECB’s stress tests for the banking sector typically anticipate, has already impacted the eurozone economy. The manufacturing sector, which generally requires more capital for operations, already feels the effects of elevated borrowing costs, resulting in a significant decline in lending to businesses and households.
Furthermore, the services sector faces challenges after a brief post-pandemic surge in tourism. According to several forecasts, Germany, the largest economy in the eurozone, is bearing the brunt of an industrial downturn and is on the brink of recession.