The European Central Bank on Thursday confirmed its intention to hike interest rates at the policy meeting next month and downgraded its growth forecasts.
Following the latest monetary policy meeting, the Governing Council announced it intends to raise key interest rates by 25 basis points at the July meeting.
The ECB expects a further hike at the September meeting, but said the scale of that increment would depend on the evolving trajectory of the medium-term inflation outlook.
For now, the interest rates on the main refinancing operations, marginal lending facility and deposit facility remain unchanged at 0.00%, 0.25% and -0.50%, respectively.
“Beyond September, based on its current assessment, the Governing Council anticipates that a gradual but sustained path of further increases in interest rates will be appropriate,” the ECB said in a statement Thursday.
“In line with the Governing Council’s commitment to its 2% medium-term target, the pace at which the Governing Council adjusts its monetary policy will depend on the incoming data and how it assesses inflation to develop in the medium term.”
Annual consumer price inflation across the 19-member euro area hit a fresh record high of 8.1% in May, but the ECB in its previous guidance indicated that a first rate hike would only come following the formal end of its net asset purchases on July 1.
Markets had been eagerly awaiting the meeting in Amsterdam on Thursday, the Governing Council’s first outside of Frankfurt, Germany, since the onset of the coronavirus pandemic, for signs of how aggressive the shift in interest rates will have to be in the coming months.
Policymakers face the challenge of reining in inflation without compounding the economic slowdown resulting from the war in Ukraine and the associated sanctions and embargoes imposed between the European Union and Russia, previously a key source of energy imports for the bloc.
Economists have been torn on whether to expect hikes of 25 basis points or 50 basis points at the July and September meetings, with the ECB broadly expected to climb out of negative rate territory by the end of September from its current historic low of -0.5%.
The euro initially retreated following the decision before rebounding to a 0.5% gain against the dollar by midafternoon.
Slowing growth, higher inflation
The ECB also downgraded its growth forecasts and upwardly revised its inflation projections. Annual inflation is now expected to hit 6.8% in 2022, declining to 3.5% in 2023 and 2.1% in 2024. This marks a substantial increase from its March projections of 5.1% in 2022, 2.1% in 2023 and 1.9% in 2024.
Growth forecasts were revised down significantly to 2.8% in 2022 and 2.1% in 2023, and revised up slightly to 2.1% in 2024. This compares with projections at the ECB’s March meeting of 3.7% in 2022, 2.8% in 2023 and 1.6% in 2024.
The Governing Council also said it stands ready to adjust all of its policy instruments to ensure that inflation stabilizes toward its 2% target over the medium term.
“The pandemic has shown that, under stressed conditions, flexibility in the design and conduct of asset purchases has helped to counter the impaired transmission of monetary policy and made the Governing Council’s efforts to achieve its goal more effective,” Thursday’s statement said.
“Within the ECB’s mandate, under stressed conditions, flexibility will remain an element of monetary policy whenever threats to monetary policy transmission jeopardise the attainment of price stability.”
Randall Kroszner, professor of economics at the University of Chicago and a former governor of the Federal Reserve System, told CNBC ahead of Thursday’s meeting that it was “very important” that the ECB began to move on interest rates.
The U.S. Federal Reserve started raising rates in March and implemented a 50 basis point hike in May, its largest in 22 years, with Federal Open Market Committee meeting minutes pointing to further aggressive increases ahead. The Bank of England has hiked rates at four consecutive meetings to take the base interest rate to a 13-year high.
“Inflation is very high, it has the potential to become entrenched unless [ECB policymakers] move, and they move aggressively and make it clear that they are going to be moving further,” Kroszner told CNBC’s “Squawk Box Europe” on Thursday.
“They run the risk of inflation becoming entrenched, inflation expectations becoming unanchored, and having to raise rates much higher than they otherwise would have to.”
However, Kroszner expressed empathy with the difficult position in which the Governing Council finds itself, given Europe’s proximity to the war in Ukraine, interdependence with Russia and therefore state of economic peril.
“The concern that they have is that there are so many negative shocks coming from the war, sanctions, uncertainty, that the economy is going to slow down even without raising rates, so the inflationary pressures are going to come off,” he said.
“But there is sufficient inflationary pressure and sufficient risk of inflation expectations becoming unanchored, that they have really got to get moving.”
Anna Stupnytska, global macro economist at Fidelity International, said continued upward surprises in European inflation and evidence of its persistence, along with the Fed’s aggressive tightening path, were heaping pressure on the ECB to “front-load” policy normalization.
“While the risk of de-anchoring in longer-term inflation expectations does not seem high, rapid widening in policy differentials versus the Fed does present challenges for the ECB, with EURUSD re-pricing in the spotlight,” she said.
“But doing too much too soon would arguably be a riskier strategy for the ECB in light of a weakening growth backdrop as well as the risk of peripheral spread fragmentation.”
