ECB raises rates by another 75 bps in unprecedented move

The European Central Bank, which is the nodal central bank for the EU members, has announced an unprecedented 75 basis points hike in the benchmark interest rates. This comes in the aftermath of 75 bps rate hike effected in the previous meeting. In the last  2 meetings of the ECB, the rates have been hiked from 150 bps and in the last 3 meetings, the rates have been hiked by 200 basis points. This is the fastest pace of rate hikes by the ECB in recent memory and this interestingly comes in the aftermath of the Fed already facing a likely recession by the middle of next calendar year.

The last time the ECB rates were higher than this level was back in December 2008 when the ECB rates were at 2%. From 2012 till 2014, the ECB rates remained at zero levels in a bid to boost growth across the EU region with cheap access to funds. Then from 2014 till mid-2022, the ECB rates remained in the negative zone (you pay to deposit money). Since September 2019, the ECB rates have been at -0.50%. In July 2022, the ECB rates were hiked by 50 bps to zero levels. Then in September 2022, the rates were hiked by 75 bps to 0.75% and now in the latest round, the ECB has hiked rates by another 75 basis points to 1.50%.

Also read: Reuters poll hints at another 75 bps rate hike by the Fed in November

Will the ECB cut the size of its balance sheet?

Like the US has a problem of a huge balance sheet due to supporting the liquidity in the system with asset purchases, the ECB also has a problem of similar magnitude. Its current balance sheet size stands at $8.8 trillion caused by years of liquidity support post the global financial crisis and again post the pandemic. The question that is doing the rounds is whether the ECB would also start to reduce the balance sheet by unwinding the bond holdings. However, the ECB chief Christian Lagarde has clarified that the unwinding of the bond portfolio would have to wait as it may be too early for quantitative tightening.

The unwinding of the balance sheet by the ECB would depend on the inflation reaction and the growth impact. Unlike the US which is one economy, the ECB is a collection of economies with different levels of macroeconomic strength. Hence the unwinding policy has to be more calibrated, especially considering that unwinding a balance sheet of the size of $8.8 trillion would result in a massive liquidity crunch in the EU economies. Hence, the unwinding would largely depend on the way the rate hikes impact inflation and how quickly the rate hikes get transmitted through the financial system in the EU.

More rate hikes likely going ahead?

While there is not much clarity on that front, there is clearly going to be more rate hikes with EU inflation nearing double digits. To add to their problems, the Euro has weakened to almost come to parity with the dollar and that is likely to result in a lot of imported inflation. The main problem in Europe is that the energy costs were in check as long as Russia was supplying them oil and gas. However, with sanctions likely to come into effect from December, the inflation problem could just about worse in Europe. That would mean more rate hikes may be on the anvil by the ECB.

Even the ECB has confirmed that its rate hike cycle is not yet over. Christian Lagarde has also indicated at various forums that if the inflation stays adamant at double digit levels, then the ECB may have no choice but to hike rates further and, perhaps, even more aggressively than in the past. Like the US Federal Reserve, the ECB is also targeting to bring down inflation to a target level of 2%, but that looks extremely far-fetched for the time being. The consensus is that in the next meeting in December, the rate hike would be to the tune of 50 basis points, but it is not too clear what is the terminal rate of interest that ECB is targeting.

If the Fed is accused of being late to start the rate hike process, the ECB procrastinated even more. That has created a situation wherein aggressive rate hikes have become inevitable. Like other central banks, the ECB also believed that inflation was supply chain driven and would vanish once the supply chain constraints vanished. However, it has not worked out that way. That would mean the ECB could hike rates more aggressively in an effort to deal with inflation. In the process, the ECB risks negating the nascent recovery in the EU economies, but that is a problem that the ECB looks willing to live with.