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26th Sep 2022

European Central Bank hikes interest rate by 0.75 percent

  • The ECB's headquarters, in Frankfurt (Photo: ECB/Flickr)
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The European Central Bank (ECB) has raised interest rates by 0.75 percent, the largest single increase since its founding in 1998, which as a consequence brings the base interest rate for banks up to 0.75 percent.

"The governing council took today's decision and expects to raise interest rates further because inflation remains far too high," bank president Christine Lagarde told press on Thursday (8 September).

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According to Eurostat estimates, average EU inflation hit 9.1 percent this month, the highest in 40 years, and pressure to take major action intensified in the past few weeks.

But the bank is in a difficult position. Economic sentiment in Europe is now lower than on the eve of the financial crisis in 2009, suggesting a winter recession is likely.

Increasing borrowing costs now may exacerbate that economic downturn, but the ECB expects inflation may rise further in the near term, and it has a mandate to bring it down to two percent.

Calls for monetary tightening are also fuelled by the fact that the eurozone economy has not yet entered recession, and the jobless rate is at a record low of 6.6 percent.

"We shouldn't delay further rate hikes for fear of a possible recession," German chief central banker Joachim Nagel said last week, a call supported by Dutch central banker Klaas Knot.

This time the logic is driven by the belief that a jolt to the system by "front-loading" interest rates just ahead of a full-blown crisis will stabilise prices, which will be "cheaper" in the long run, Nagel said.

But demand is already collapsing without the input of Europe's central bank. "Very high energy prices are reducing the purchasing power of people's incomes and they are still constraining economic activity," the ECB wrote in a statement.

According to Goldman Sachs, a typical European household may spend as much as €500 monthly on energy bills next year, a tripling of last year's prices.

Real negotiated wages in 2022 have dropped 6.5 percent on average in the Eurozone, 8.1 percent in Spain, 7.5 percent in the Netherlands and Italy.

The ten-percent of poorest households in the United Kingdom are projected to spend 50 percent of their income on energy.

Although the ECB still expects the European economy to grow by 0.9 percent, if Russia cuts off all gas supply the bank actually projects a recession for 2023.

As it is, disposable income is dropping much faster than during the height of the 1970s stagflation, a period of low growth and high inflation, which the current moment is often compared with. Tightening the money supply will dampen wages even further.

Vitor Constâncio, a former ECB vice-president, told Italian newspaper La Stampa that the 75-basis-point increase is a "risky mistake" because of the likely chance the European economy will enter a recession before the end of the year.

David Malpass, president of the World Bank, said rate hikes are also ill-suited to address current inflation, which is driven mainly by exorbitant energy prices — a point ECB president Christine Lagarde has repeatedly made in the past.

"I cannot reduce the price of energy. I cannot convince the big players to reduce gas prices," Lagarde also said to this effect on Thursday. "Monetary policy is not going to reduce the price of energy."

Supporting the decision to go for a big rate hike are the large stimulus measures announced by the eurozone governments to protect households and businesses against high energy prices.

Germany has announced €65bn in support measures, the Netherlands €16bn. The assumption is these investments will fuel demand and increase inflation, but many of the proposals now on the table will limit the price of energy or gas, which would reduce overall inflation.

Hiking rates at this time increases the cost of these interventions, which will be felt especially hard by weaker economies.

Greece is spending 3.7 percent of its annual economic output on support measures for households and businesses, the highest of any EU country, according to Brussels-based Bruegel.

Tellingly, Greek Central Bank governor, Yannis Stournaras, was one of the last governing council members to urge "gradual" rate rises to "ensure a soft landing" for the economy.

The bank's council will meet again on 27 October.

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