The European Central Bank raises interest rates for the first time in 11 years. But in Italy, political turmoil is back.
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The European Central Bank on Thursday raised interest rates for the first time in 11 years in a bid to ease runaway inflation in the eurozone.
The ECB, the central bank of 19 euro-using countries, surprised markets by raising its base rate by 50 basis points, bringing the deposit rate to zero. Economists had expected a smaller increase of 25 basis points.
“The Governing Council saw fit to take a larger first step towards normalizing the discount rate than indicated at its previous meeting,” the ECB said in a statement on Thursday.
The Frankfurt Institute has kept rates at historic lows, in negative territory since 2014, as it dealt with the region’s sovereign debt crisis and the coronavirus pandemic.
The euro surged to a session high on news of a more aggressive rate hike and traded at $1.0257. Italian 10-year bond yields also jumped on the news, boosting gains after reacting to Prime Minister Mario Draghi’s resignation earlier Thursday.
The ECB also said that this change in interest rates “will support the return of inflation to the Governing Council’s medium-term target by strengthening the anchoring of inflation expectations and ensuring that demand conditions are adjusted to meet the medium-term inflation target.” The inflation target of the Central Bank is 2%.
The ECB had previously signaled it would raise rates in July and September as consumer prices continue to rise, but it was unclear if this would go so far as to bring rates back to zero. The ECB’s deposit rate is now 0%, the prime refinancing rate is 0.5% and the credit limit is 0.75%.
Seema Shah, chief strategist at Principal Global Investors, said in an email that the ECB is not tightening its policy amid strong economic growth “and certainly not accompanied by holiday smiles.”
“The ECB is entering a sharply slowing economy, facing severe stagflation. [when inflation is high and growth is low] a shock that is beyond its control, and also faced with a political crisis in Italy that presents a complex sovereign risk dilemma,” she said, adding that “there is no other developed market central bank in a worse position than the ECB.”
Karsten Brzeski, Head of Global Macro at ING Germany, said: “For the first time since 2011, the Bank has raised interest rates, and it did so with a bang. The 50 basis point hike in rates and the softening of the outlook shows that the ECB believes the Window for a series of rate hikes is rapidly closing.”
The first inflation reading in June showed a record high of 8.6%. However, some investors are skeptical about the actions of the ECB, as they predict a recession at the end of this year. Back in June, ECB forecasts indicated an inflation rate of 6.8% for this entire year and 3.5% in 2023. In terms of growth, the central bank estimates GDP at 2.1% this year and next.
One of the biggest uncertainties going forward is whether Russia will completely cut off natural gas supplies to Europe. Moscow has been accused of weaponizing fossil fuels as the EU imposes tough sanctions on the Kremlin for its unprovoked attack on Ukraine.
Natural gas flows have fallen by about 60% since June, and the critical Nord Stream 1 pipeline resumed deliveries on Thursday after maintenance, albeit at a reduced capacity.
Europe’s economic commissioner Paolo Gentiloni said that a complete shutdown of supplies from Moscow, because Europe is so dependent on Russian hydrocarbons, could lead to a recession in the eurozone this year, although this is not currently the EU’s base case.
Tool against fragmentation
Meanwhile, on Thursday, investors kept a close eye on the details of the ECB’s new anti-fragmentation tool, which aims to support heavily indebted countries such as Italy.
The Central Bank named this new instrument TPI (Transmission Protection Instrument). It could be activated to counter “unreasonable, erratic market dynamics that pose a serious threat to the spread of monetary policy in the euro area,” the report said.
“The scale of TPI purchases depends on the severity of the risks associated with the policy transition,” the ECB added, while saying that additional details will be released at 2:45 pm London time on Thursday.
Expectations point to some contingency between undertaking rigorous domestic reforms and qualifying for this new tool. This becomes especially important in the context of Italian politics, where early elections are expected to take place in the autumn after Prime Minister Mario Draghi stepped down on Thursday morning.
A credible government that sticks to the targets agreed with the European Commission will be critical if it is to capitalize on the new instrument.
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