The European Central Bank entered a new era on Thursday, as policymakers clearly stated their plan to raise interest rates next month for the first time in more than a decade to tackle inflation.
To prepare for that move, the bank confirmed that it would stop growing its bond-buying program this month. After eight years, the end of the bank’s negative interest rate policy and huge asset purchase program, which has scooped up trillions of euros of government debt, is in sight.
The end of those programs, and the higher interest rates ahead, are a turnaround from years of policies that have tried to stoke lackluster inflation and economic growth in the countries that use the euro.
But recently across the eurozone, inflation has outpaced economists’ expectations: The annual rate of price increases climbed to 8.1 percent in May, the highest since the creation of the euro currency in 1999. Policymakers have been spurred into faster action against inflationary forces that are being stoked by the war in Ukraine.
“High inflation is a major challenge for all of us,” the bank said in a statement, as it warned that inflationary pressures had “broadened and intensified,” reaching more goods and services. Most of the goods and services used to measure inflation are rising more than 2 percent, exceeding the central bank’s target. Inflation excluding food and energy prices, which tend to be more volatile, is also expected to outstrip the bank’s 2 percent target through 2024.
The central bank was explicit about raising rates, saying it planned to raise its three key rates by a quarter-point at its July meeting. The bank added that it expected to raise rates again in September. After that, there will be a “gradual but sustained path” of future increases, the bank said.
If the inflation outlook “persists or deteriorates,” the bank said, a larger jump in interest rates — mostly likely half a percentage point — would be appropriate in September, though policymakers would need to determine if such a move would apply to all key rates. Raising interest rates by half a percentage point has become more common recently as prices rise quickly around the world, with central banks in the United States, Canada and Australia opting for such a move.
For the eurozone, a half-point increase was ruled out for July because it is “good practice” to start with an increase that is “sizable, not excessive and indicates a path” that the central bank is on, Christine Lagarde, the president of the bank, told reporters in Amsterdam on Thursday.
At the moment, the central bank’s deposit rate, which is what banks receive for depositing money with the central bank overnight, is at minus 0.5 percent, in effect a penalty meant to encourage banks to lend the money rather than keep it at the central bank. The rate was first cut below zero in mid-2014 as the inflation rate fell toward zero.
“The European Central Bank is finally getting serious about tackling inflation risks,” Holger Schmieding, the chief economist at Berenberg Bank, wrote in a note to clients, adding that the central bank took a “harder line” than expected.
Stocks in Europe fell, with the Stoxx Europe 600 index closing 1.3 percent lower. Even though traders had been betting on several increases in interest rates this year, government bonds also sold off, pushing up their yields, which are a measure of borrowing costs. The euro fell against the dollar.
But not all analysts agreed that the bank was doing enough. Analysts at Commerzbank wrote that policymakers were “acting too hesitantly” and that inflation would average “well above” the target in the coming years.
Valentin Marinov, a currency strategist at Crédit Agricole, said the bank’s priority had shifted to tightening monetary policy and away from ensuring “favorable financial conditions,” a change that was weighing on euro-denominated assets. This shift could also “add to market concerns about the eurozone growth outlook,” he said.
The central bank updated its forecasts for the economy on Thursday, painting a grim picture of rising inflation and a deteriorating growth outlook as the war in Ukraine disrupts trade and pushes energy and commodity prices higher. Inflation is also squeezing incomes, which is weighing on consumer confidence.
The war “is severely affecting the euro area economy, and the outlook is still surrounded by high uncertainty,” Ms. Lagarde said. At the same time, China’s zero-Covid policy is restricting manufacturing and worsening supply bottlenecks. “As a result, firms face higher costs and disruptions in their supply chains, and their outlook for future output has deteriorated,” she said.
The bank said the eurozone economy would grow 2.8 percent this year, slower than the previous forecast of 3.7 percent, and then grow 2.1 percent in 2023 and 2024.
The need to tackle inflation is outweighing the bank’s concerns about a slowing economy. “Inflation will remain undesirably elevated for some time,” Ms. Lagarde said.
This year, inflation will average 6.8 percent, up from 5.1 percent projected in March, and fall to 3.5 percent next year. The bank forecast the annual inflation rate to be 2.1 percent in 2024, still above the 2 percent target, cementing the conditions for raising interest rates.
For much of the past decade, policymakers have been battling inflation that was too low. The European Central Bank has been slower to tighten its monetary policy than central banks in the United States and Britain because it expected the sharp rise in inflation to be temporary and reverse relatively quickly as energy prices settled. In Europe, there were also fewer signs of second-round inflationary effects, such as workers demanding large wage increases in response to rising prices. But wage growth has started to pick up in recent months, the bank said, and there are early signs that longer-term inflation expectations are starting to rise above the bank’s target, something the central bank is keen to avoid.
As a precursor to raising rates, the bank’s bond-buying program, a way of keeping borrowing costs down and injecting money into the system, will stop making net purchases by the end of the month, policymakers said. (A special pandemic-era bond-buying program ended in March after 1.7 trillion euros in purchases.) Before the program ends, the bank is set to buy €20 billion in mostly government bonds in June.
The bond-buying program started in 2015, and the bank’s purchases have grown and shrunk as policymakers tried to heat up and cool down the economy as necessary. As of May, holdings in the program amounted to more than €3 trillion in bonds.
Officials will be carefully watching the borrowing costs of countries with high debt burdens, such as Italy, as interest rates rise. The aim is to ensure that the interest rates they pay on their bonds don’t diverge too much from those of other members in the bloc, like Germany, so that countries across the common currency don’t face different financial conditions that disrupt the effectiveness of monetary policy.
After Thursday’s policy meeting, the spread between Italy’s 10-year government bond yield and Germany’s continued to grow, reaching 2.16 percentage points, the widest since early 2020, when the onset of the coronavirus pandemic roiled financial markets.
The bank said that, if needed, it would use the reinvestment of proceeds from maturing bonds in its pandemic-era bond-buying program to avoid this so-called market fragmentation.
There is no specific level of government bond yields or lending rates that would trigger the use of this flexibility, Ms. Lagarde said, but the bank “will not tolerate fragmentation that would impair monetary policy transmission.”
The bank’s unwillingness to define the conditions that would activate this flexible reinvestment policy means Italian bonds are “unlikely to find any comfort anytime soon,” Claus Vistesen, the chief eurozone economist at Pantheon Macroeconomics, wrote in a note. On Thursday, the yield on Italy’s 10-year bonds jumped 0.22 percentage points to 3.6 percent, the highest since late 2018.
June 9, 2022
An earlier version of this article misstated the European Central Bank’s forecast for eurozone economic growth this year. It predicts growth of 2.8 percent for 2022, not 2.1 percent.