The European Central Bank (ECB) has raised borrowing costs in the eurozone for the first time in over a decade, ending its long tryst with negative interest rates. The momentous shift to a normal monetary policy where you are rewarded, not penalized for parking your money in a bank has come late but has done so with a bang.
More than three-quarters of central banks in the industrialized world have already raised interest rates and have done so almost four times as they look to tame the raging inflation. The US Federal Reserve (FED) executed its biggest hike in nearly three decades in June and is widely expected to follow it up with another bumper hike later this year.
Like in the United States, inflation in the eurozone has also been on a record-breaking spree, partly thanks to the ECB's ultraloose monetary policy. But the central bank policymakers didn't seem much perturbed for the longest time, keeping the money taps wide open with negative interest rates even when inflation soared to nearly four times the bank's 2% target.
And now, as it looks to make amends, it seems determined to bring down inflation to 2% by shrugging off its obsession with keeping the financial markets in good humor and by not staying the course on its forward guidance. Fears of losing credibility didn't deter the central bank from embarking on its rate-hike cycle with a 50 basis point bump — double the size it had signaled in June. The right move given how much the inflation situation has worsened in the weeks following the June announcement.
Ditching forward guidance
Most central banks start their tightening cycle with an incremental increase just to communicate their hawkish intention and see how markets respond to it.
But these are hardly normal times, as the ECB's big move underscores. Europe is witnessing a major war that has upended energy markets and global supply chains, driving up energy and food prices. There is hardly any scope for gradualism right now. A slow response risks worsening the cost-of-living crisis in Europe and could push the euro area into a recession much deeper than is being feared now.
The shared currency euro has been battered to its weakest levels against the US dollar in 20 years, largely due to ECB's past inaction that has created a wide crater between the interest rate levels in the US and the eurozone. The sinking currency will add to the burden on European households and businesses as it would make imports, which are mostly denominated in dollars, more expensive, and also end up driving up local prices. The surprise 0.50% hike is a welcome boost for the euro.
Even as inflation expectations remain anchored for now, there are enough signs that inflation would stay elevated for the next few years. A strong job market is among them. A severe scarcity of workers would continue to drive up wages even in the event of a slowdown. This would prompt companies to push up prices further as they look to guard their profit margins, setting off a so-called wage-price spiral that keeps inflation high.
Recession fears vs. actual recession
The ECB's big hike comes in the backdrop of a worsening economic outlook. The eurozone is, by many accounts, headed into a recession amid fears of Russia shutting down natural gas supply.
In this light, it only made more sense for the ECB, which has been looking to put an end to negative interest rates, to go for a bigger hike now rather than wait for September, when the economic situation is most likely to worsen. In other words, the ECB has decided to inflict pain now when there is only a risk of recession than doing so during an actual recession, even if it means shocking financial markets and hurting the ECB's credibility as being predictable.
Stick to inflation mandate
The ECB has a tricky job of ensuring price stability in a bloc consisting of diverse economies. An aggressive rate hike could stir up a sovereign-debt storm in weaker members of the eurozone.
The central bank's task has been complicated by the political crisis in Italy where politicians have returned to their pastime of musical chairs. The ECB should abstain from becoming the backstop against a spike in borrowing costs caused by politicians' inability to put their house in order.
It looks like the central bank — which is often criticized for giving precedence to supporting weaker economies by keeping borrowing costs low over fulfilling its price stability mandate — is prioritizing fighting inflation for now.
As the ECB approaches the 10th anniversary of Mario Draghi's vow of doing "whatever it takes" to prevent the collapse of the euro, it should be mindful that it had failed in driving up inflation to its 2% target level in all those years. Now, it's once again predicting reaching that target in 2024. Getting there would need many more surprises.
Edited by: Uwe Hessler