| 1 October 2023, Sunday |

European Central Bank raises interest rates to record high amid economic challenges

The European Central Bank (ECB) took a noteworthy step on Thursday when it increased its key interest rate to an all-time high of 4 percent. Nevertheless, given the economic challenges confronting the euro zone, the ECB indicated that this rate hike, representing the 10th increase in its 14-month campaign against inflation, is probably its final move in this regard.
The ECB, which oversees monetary policy for the 20 countries sharing the euro, also revised its inflation and economic growth forecasts. It now anticipates that inflation will decrease more slowly towards its 2 per cent target over the next two years while revising downward its growth projections.

This present situation indicates the challenges faced by ECB policymakers as inflation rates continue to exceed the target rate, yet high borrowing costs and economic difficulties in China are hampering overall economic activity.
Consequently, the ECB sent a strong signal that its interest rate hikes have likely come to an end. This prompted a drop in euro zone bond yields and the euro’s value, while European shares gained as investors speculated that rate cuts might be on the horizon in the coming year.

Reuters quoted a statement made by the ECB saying, “Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.”

However, this return to target inflation is now expected to occur at a slower pace than previously projected. The ECB’s previous forecasts suggest inflation rates of 5.6 per cent in 2023, 3.2 per cent in 2024, and 2.1 per cent in 2025.

The 25-basis-point interest rate hike pushed the rate that the ECB pays on bank deposits to 4 per cent, marking the highest level since the launch of the euro currency in 1999. When the ECB began to strictly control its monetary policy in July 2022, this rate came to reach a low of minus 0.5 per cent, indicating that banks had to pay to keep their funds safe with the central bank.

ECB President Christine Lagarde did not entirely dismiss the possibility of continued rate hikes, emphasising that interest rates would need to stay at restrictive levels for a while. Reuters quoted her at a press conference as saying, “The focus is going to move, going forwards, to the duration, but that is not to say, because we can’t say that now, that we are at peak.”

Nevertheless, market reactions and forecasts have indicated scepticism about the ECB’s commitment to keeping borrowing costs high for an extended period. Traders now anticipate the possibility of a rate cut as early as June, up from expectations of a cut in September prior to Thursday’s decision, which shall follow two more rate cuts anticipated at the end of 2024.

The lower market rates following the hike raise questions about the ECB’s determination to maintain elevated borrowing costs. Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, commented, “The ECB won’t be happy about this.”

While the ECB’s decision is being closely watched, the U.S. Federal Reserve is widely expected to stick to the same rates at its upcoming policy meeting. In contrast, the Bank of England is expected to proceed with a rate hike, despite some adjustments in expectations following the ECB’s decision.

Responding to questions about whether the ECB’s downgrade of its growth forecasts implied a regional recession as the base-case scenario, Lagarde maintained that the slowdown was temporary, expressing confidence that growth would rebound in 2024.

The ECB’s adjustment of its 2024 inflation estimate played a role in the discussions, highlighting concerns that inflation, currently above 5 per cent, might remain at elevated levels for an extended period.

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