Tuesday

3rd Oct 2023

ECB set to raise rates, amid monetary and political turmoil

  • European Central Bank president Christine Lagarde has to navigate a strong dollar, rising prices, an energy crunch, and an Italian political crisis (Photo: Council of the EU)
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The European Central Bank is set to increase interest rates in the eurozone at its governing council meeting on Thursday ( 21 July).

Other central banks, such as the US Federal Reserve, have already increased borrowing costs in an effort to stem inflation, but the ECB has been reluctant to do so out of fear that higher borrowing costs may push some weaker EU economies into recession, which would also drive down the euro even further.

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But the threat of a total Russian gas cut-off, continuing high inflation, plus the rate hikes by the Federal Reserve, have forced the hand of the bank's management.

Since the beginning of the Ukraine war, the euro has lost 15 cents to the dollar as investors have fled the euro, and its currency exchange rate this week reached parity for the first time since 2002.

Because oil is traded using dollars, it has become relatively more expensive for EU countries to buy oil, further exacerbating the price crisis in the EU.

Speaking last Wednesday (13 July), French bank governor François Villeroy de Galhau said a lower euro is "good news" for exporters but also noted that "unfortunately, it raises inflation a bit."

"The exchange rate isn't something we set, but we follow it because it counts for inflation," he added.

With no further media communication planned until this week's key decision, no new remarks may be made on the subject.

Fragmentation

The Frankfurt-based bank, however, does not have much room to manoeuvre.

The ECB is the central bank for 19 member states instead of the usual one, which makes its decision-making more complex.

It has to keep inflation at two percent, but it also has to prevent its borrowing decision from increasing the so-called 'spreads' — the interest-rate difference between countries, specifically Italy and German bonds, which speculative bond investors drive.

To prevent borrowing costs among eurozone governments from diverging too much, the ECB is expected to launch a new bond-buying programme on Thursday (21 July) — a so-called anti-fragmentation tool.

The aim is to ensure that monetary policy works similarly across the bloc. If borrowing costs in some regions are far higher than in others, the economic downturn may hit some regions harder than others.

This happened during the euro crisis between 2011 and 2014, when Italian and Greek borrowing costs spiked, causing a debt crisis that threatened to blow up the union.

This was only prevented when former ECB president Mario Draghi announced he would do "whatever it takes" and buy up all government bonds.

It turned out the strength of the statement was enough to calm speculators, and the spread was brought down without ever using the first bond-buying programme.

Current ECB president Christine Lagarde's governing council has something similar in mind with this week's anti-transmission tool.

Greek ECB governing council member Yannis Stournaras said the new tool may not need to be used if it's powerful enough to persuade investors not to test it.

"I believe that there is a lot of truth in the idea that if we convince markets that this is going to be a strong tool, we might not need it," he said. "We'll have it on the shelf. This is the good scenario."

But it is unclear how or when this policy will be implemented. The ECB will also have to define at what point spreads will become excessive.

This may not be easy.

Signalling internal disagreement, Joachim Nagel of Germany's Bundesbank said at the start of July it is "virtually impossible" to determine this — which may cause nervous bond investors to doubt the banks' determination.

It is also far from certain Lagarde's anti-fragmentation tool will be as effective as Draghi's "whatever it takes" moment because the ECB, this time around, also has to raise borrowing costs.

Resignation

Added to the complex monetary situation is new political turmoil in Italy.

Draghi last Thursday (14 July) annouced his resignation as Italian prime minister. Italian president Sergio Mattarella then rejected this, instead asking Draghi to address parliament, leaving the door open for a solution.

In an effort to create distance between monetary policy decision-making and national politics, Lagarde has stressed that the bank should not be dominated by fiscal considerations, adding that the bank's responsibility is to bring back inflation to two percent.

"We cannot surrender to fiscal dominance," she said. "We have to deliver on our mandate, which is, as many of you know, price stability."

But political turmoil in Italy adds uncertainty to an already combustible situation on Italian bond markets, adding further downside risk on this week's ECB decision.

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