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ECB raises rates more than necessary in race to curb inflation

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  • All rates are raised by 50 basis points
  • Inflation to remain ‘undesirably’ high
  • ECB backs ‘anti-fragmentation’ tool called TPI
  • ECB ‘could do great things’, says Lagarde

FRANKFURT, Jul 21 (Reuters) – The European Central Bank hiked interest rates more than expected on Thursday as fears of runaway inflation trumped growth fears even as the eurozone economy is suffering from the fallout from Russia’s war in Ukraine.

The ECB raised its benchmark deposit rate by 50 basis points to zero percent, violating its own guidance for a 25 basis point hike as it joined global peers in raising borrowing costs. This was the ECB’s first rate hike in 11 years.

Policymakers also agreed to provide additional assistance to heavily indebted currency bloc countries of the 19 countries, including Italy, with a new bond-buying scheme designed to limit the rise in their borrowing costs and thus limit financial fragmentation.

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Having ended an eight-year experiment with negative interest rates, the ECB also raised its main refinancing rate to 0.50% and promised further increases, possibly immediately after the September 8 meeting, and later even more.

ECB President Christine Lagarde said the clear deterioration in the inflation outlook and the unanimous support for the anti-fragmentation instrument justified the bigger move.

“The price pressure is spreading to more and more sectors,” Lagarde said. “We expect inflation to remain undesirably high for some time to come.” She listed the driving factors, including higher food and energy prices and rising wages.

“In the end, we decided that it would be appropriate to take a bigger step out of negative interest rates.”

But even if the ECB is moving faster now, Lagarde said, the cap rate – or the level at which the hike ends – has not changed.

The ECB gave no guidance on an expected rate hike in September, saying only that further increases would be made on an as-needed basis, with decisions to be made at each meeting.

The ECB had been guiding markets for weeks on expectations of a 25 basis point rise on Thursday, but sources close to the discussion said that 50 basis points came into play shortly before the meeting in a deal that included bailouts for debtor countries.

With inflation already approaching double-digit territory, there is a risk that it will gain a foothold well above the ECB’s 2% target, and any shortage of gas over the coming winter is likely to push prices even higher, supporting rapid price increases.

Lagarde warned that the risks to the inflation outlook were positive and increased, especially as the war is likely to drag on and energy prices remain high for longer.

Economists polled by Reuters had expected a 25 basis point rise, but the majority favored a 50 basis point hike, raising the ECB’s record low deposit rate of minus 0.5% to zero. read more

The euro edged up 0.8% to $1.0261 from trading at $1.0198 shortly before the announcement, but turned negative the day Lagarde spoke. Markets are now pricing a rate hike of nearly 50 basis points in September and are seeing an overall increase of 124 basis points for the remainder of the year.

GETTING BIG?

The new bond-buying scheme, called the Transmission Protection Instrument (TPI), is designed to limit the rise in borrowing costs in the currency bloc as policies tighten.

“The scale of TPI purchases depends on the severity of the risks associated with the policy transfer,” the ECB said in a statement. “TPI will ensure the smooth transfer of monetary policy stance to all eurozone countries.”

As ECB rates rise, the cost of borrowing rises disproportionately for countries like Italy, Spain or Portugal as investors demand a higher premium to hold their debt.

“The ECB is able to make great strides in this,” Lagarde said.

Activation of the instrument will be entirely at the discretion of the ECB, and the bank will target public sector bonds with maturities ranging from one to 10 years.

Countries will be eligible if they comply with the European Union’s fiscal rules and do not face “serious macroeconomic imbalances”. Compliance with commitments under the EU Recovery and Resilience Facility and a debt sustainability assessment will be required.

Thursday’s ECB commitment comes as the political crisis in Italy is already putting pressure on markets following the resignation of Prime Minister Mario Draghi, who was Lagarde’s predecessor at the ECB.

The yield spread between Italian and German 10-year bonds widened to 246.5 basis points during Lagarde’s press conference, not far from the 250 basis point level that triggered the ECB’s emergency policy meeting last month.

The ECB’s 50 basis point hike still leaves it behind its global counterparts, especially the US Federal Reserve, which raised rates by 75 basis points last month and is likely to move by a similar margin in July.

But the eurozone is more exposed to the war in Ukraine, and the threat of cutting off gas supplies from Russia could trigger a recession in the bloc, leaving policymakers in a dilemma of balancing growth and inflation considerations.

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Writing by Mark John; Editing: Toby Chopra, John Stonestreet and Katherine Evans

Our Standards: Thomson Reuters Trust Principles.

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