Inflation fears now take precedence over growth considerations, according to the European Central Bank's surprise interest rate increase on Thursday. This comes as the eurozone economy struggles to recover from the effects of Russia's war in Ukraine.
The ECB increased its benchmark deposit rate by 50 basis points to 0%, deviating from its own prediction of a 25 basis point increase as it increased borrowing costs alongside its international peers. It was the first rate increase in 11 years by the eurozone's central bank.
The ECB also raised its main refinancing rate to 0.50 percent, ending an eight-year experiment with negative interest rates, and promised additional rate increases, perhaps as soon as its next meeting on September 8.
The ECB declared that "further normalization of interest rates will be appropriate." The ECB stated in a statement that "the frontloading today of the exit from negative interest rates allows the Governing Council to make a transition to a meeting-by-meeting approach to interest rate decisions."
According to sources with direct knowledge of the conversation, 50 basis points were put on the table just before the meeting as indicators pointed to a further deterioration of the inflation outlook. The ECB had been guiding markets to expect a 25 basis point increase for weeks.
With inflation now at risk of rising above the ECB's 2% target and already approaching double-digit territory, any gas shortage over the upcoming winter is likely to drive prices even higher and sustain rapid price growth.
The majority of economists surveyed by Reuters said the bank should raise rates by 50 basis points instead of the 25 predicted, bringing its record-low minus 0.5 percent deposit rate to zero.
The euro strengthened by about 0.5 percent in response to the ECB's decision after hitting a two-decade low against the dollar earlier this month.
A new bond purchase program called the Transmission Protection Instrument was approved by the ECB in order to assist the 19-nation currency bloc's more indebted members and to help stop the rise in their borrowing costs and prevent financial fragmentation.
The ECB stated in a statement that "the scale of TPI purchases depends on the severity of the risks facing policy transmission. The TPI will ensure that the monetary policy stance is transmitted smoothly across all euro area countries."
For nations like Italy, Spain, or Portugal, borrowing costs rise disproportionately as ECB rates rise because investors demand a higher premium to hold their debt.
The ECB's commitment on Thursday comes as the markets are already being affected by the political crisis in Italy as a result of Prime Minister Mario Draghi's resignation.
On Thursday, the yield difference between German and Italian 10-year bonds briefly went above 240 basis points and was close to the 250 basis point threshold that forced an emergency ECB policy meeting last month.
The focus of the markets is now on ECB President Christine Lagarde's news conference at 12:45 GMT.
The ECB's rate increase of 50 basis points on Thursday still places it behind its international counterparts, especially the U.S. Federal Reserve, which raised rates by 75 basis points last month and is probably going to do the same in July.
However, because of its greater vulnerability to the conflict in Ukraine and the possibility of a cutoff in gas imports from Russia, the euro zone faces a challenge in balancing growth and inflation concerns.
The war has already damaged confidence, and rising raw material prices are reducing purchasing power.
However, it is debatable whether increasing borrowing costs during a recession would lessen or exacerbate the pain for businesses and households.
However, the ECB's primary goal is to control inflation, and excessively rapid price increases could make the issue worse by forcing businesses to automatically raise prices.
The tightening labor market in Europe also suggests that wage pressure will likely keep price growth high.
Because there is too much risk of a new "inflation regime" taking hold, some central banks, most notably the Fed, have stated openly that they are willing to crash growth in order to control inflation.
Additionally, if a recession is on the horizon, the ECB must front-load rate increases to speed up the end of its tightening cycle.
By fLEXI tEAM