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ECB Hands Down Hefty Rate Increase as Inflation Continues to Plague Europe

By:
Carolane De Palmas
Published: Oct 27, 2022, 14:42 GMT+00:00

The European Central Bank (ECB) has increased its key rates another 75 basis points at its October 27th Monetary Policy Meeting.

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It’s the second consecutive increase of this size and third increase this year. While it may be the quickest pace that the ECB has ever raised its rates, analysts widely expect that there will be more large hikes of this nature to come. Inflation is still around 5 times higher than the ECB’s target mandate of 2%.

Meeting Details

The interest rate on the main refinancing operations is increasing to 2.00%, while interest rates on the marginal lending facility will jump to 2.25%, and the deposit facility rate will be lifted to 1.50%. These new rates will all be due to come into effect from the 2nd of November.

In its statement, the Governing Council noted that it had made “substantial progress” in its efforts to withdraw from its previously loose monetary policy that supported growth throughout the pandemic. Further rate increases are expected by the ECB, the size of which is to be decided on a meeting by meeting basis, as they take into consideration the “evolving outlook for inflation and the economy.”

Additionally, the ECB has now started the process of reducing its 8.8 trillion euro balance sheet, which would likely result in higher borrowing rates and might even be seen by some as a disguised rate rise.

Targeted Longer-Term Refinancing Operations, or TLTROs, are ultra-cheap three-year loans totalling 2.1 trillion euros that the ECB used to reduce the subsidy it gives to such lenders. Commercial banks may oppose this move, but the ECB was confident in its decision.

“In view of the unexpected and extraordinary rise in inflation, it needs to be recalibrated to ensure that it is consistent with the broader monetary policy normalization process and to reinforce the transmission of policy rate increases to bank lending conditions,” the bank said.

According to the ECB, in the future, the interest rate for TLTRO operations will be linked to the main ECB interest rates that are currently in effect. The modification aims to promote early loan payback.

Better Late Than Never?

It’s the same story across much of the world over nearly the whole of 2022. Inflation has been climbing rapidly on the back of soaring energy prices, supply chains are still being mended from the difficulties of the pandemic, China is still enacting cruel lockdowns impacting manufacturing, and the conflict in Ukraine is an ongoing factor, among other things.

A recent Reuters poll found that inflation may not reduce back to the target range in the Eurozone until the end of 2024 – or later – even with the current frontloading of rates.

The Governing Council worries that the price of everyday products and services is at risk of becoming entrenched, according to the minutes from the previous monetary policy meeting held in September.

This means that consumers will have expectations for higher prices that will later impact things like rent, school fees, medical services, and others that aren’t so easily re-adjusted back down. From there inflation can spiral and become “self-reinforcing,” as wages potentially have to be lifted and operational costs for businesses increase as a result.

With winter just around the corner, the fear is that the ECB will be forced to further tighten its monetary policy in a similarly aggressive fashion that will put enormous pressure on already stretched household budgets. If it turns out to be a harsh, cold season, some may be forced to make difficult decisions about whether or not they’re able to afford the cost of the electricity to heat their homes.

Recent Manufacturing and Services Purchasing Managers Index reports (PMI) for the Eurozone suggest that the sectors are predictably suffering a contraction in business activity. The index has been falling at its fastest rate in almost two years, as factories struggle with the cost of energy.

With all of this in mind, there’s much to consider for the central bank in these decisions, while the impact of these rate increases spooks investors and puts additional stress on the bond market. The possibility of a deep recession is very much still on the cards.

Where to Go From Here?

Many of the ECB’s central bank peers have lifted rates earlier and more forcefully in recent months to get on the front foot of dampening demand, chief of which is the Federal Reserve, which has lifted rates by 300 basis points so far this year.

Questions remain about how this strategy is actually working out for the US, in light of recent CPI data. Core inflation, which strips out the costs of food and energy, still increased 6.6% annually last month, with the overall CPI still remaining largely unchanged from the month before.

Rakeen Mabud, chief economist at the Groundwork Collaborative thinktank weighed in on the situation recently, saying, “Raising interest rates isn’t working, and the Fed’s overly aggressive actions are shoving our economy to the brink of a devastating recession,” she said. “Supply chain bottlenecks, a volatile global energy market and rampant corporate profiteering can’t be solved by additional rate hikes.”

If the US’s experiences provide some insight into what the Eurozone can expect from its tightening conditions, then it could prove to be a long and treacherous road ahead for the 19 countries that make up the bloc. Especially since the US also isn’t facing the same deepening energy crisis as Europe, and the impact from the conflict in Ukraine isn’t quite as pressing.

ActivTrades’ Forex data shows that the EUR/USD pair is heading down towards parity once more after the ECB meeting. Volatility remains high on this currency pair, as the USD is strongly strengthening against its peers this year.

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About the Author

Carolane graduated with a Masters in Corporate Finance & Financial Markets and got the AMF Certification (Financial Markets Regulator in France). Afterward, she became an independent trader, investing mostly in European and American stocks/indices.

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