ECB braces for first interest rate hike in a decade

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The European Central Bank will enter a new era on Thursday, as policymakers are expected to confirm when its bond-buying program will end and reaffirm its intention to raise interest rates over the summer for the first times in more than a decade.

Across the euro zone, inflation exceeded economists’ expectations: the annual rate of price increase soared to 8.1% in May, the highest since the creation of the euro in 1999. Policymakers have prompted to act more quickly against the inflationary forces fueled by the war in Ukraine.

The central bank will also provide updated forecasts for the economy on Thursday, which should paint a grim picture of rising inflation and deteriorating growth prospects. Last month, the European Commission lowered its forecast for economic growth to 2.7% for this year, from an estimated 4% in winter, and said inflation would average 6.8% for the year.

But the need to fight inflation outweighs worries about a slowing economy.

For much of the past decade, policymakers have struggled with too low inflation. But as consumer prices began to climb and spread to more goods and services in late 2021, the bank accelerated its process of so-called policy normalization, including the possibility of raising its rate. negative interest. Inflation forecasts for 2024 will be a crucial sign of whether medium-term inflation is likely to be at or above the bank’s 2% target, further strengthening the conditions for monetary tightening.

In late May, Christine Lagarde, the bank’s president, laid out in unusually clear terms the expected path of interest rate hikes, pointing to increases in July and September. “Based on the current outlook, we will likely be able to exit negative interest rates by the end of the third quarter,” Ms. Lagarde wrote in a blog post. The bank’s more hawkish tone has also helped steer the euro away from a five-year low against the dollar in recent weeks. Ms. Lagarde will host a press conference in Amsterdam on Thursday afternoon.

Right now the central bank deposit rate, which is what banks get for depositing money with the central bank overnight, is minus 0.5%, effectively a penalty intended to encourage banks to lend money rather than keep it at the central bank. The rate was first brought below zero in mid-2014 when the inflation rate fell towards zero.

Traders will be listening carefully for clues about the magnitude of potential rate increases. Financial markets are currently betting on a deposit rate hike of more than 130 basis points, or 1.3 percentage points, by the end of the year.

The central bank’s chief economist recently said increases would likely be a quarter of a percentage point at a time, but some policymakers have suggested that an above-normal increase of half a percentage, could be justified.

Bank of America analysts expect the central bank to raise interest rates by 1.5 percentage points this year. “The pressure to go faster (and less incrementally) will continue to grow from here,” they wrote in a note to clients.

As a precursor to rising rates, the bank’s bond-buying program, a way to lower borrowing costs and inject cash into the system, is set to end in early July, announced the decision makers. (A special pandemic-era bond-buying program ended in March after 1.7 trillion euros in purchases.) This month, the bank is expected to buy 20 billion euros. mainly government bonds. The program began in 2015 and its purchases have risen and fallen as policymakers try to warm and cool the economy as needed. In May, the program’s holdings amounted to more than 3 trillion euros in bonds.

But even if the bank stops expanding its asset purchase programs, officials will carefully monitor borrowing costs for highly indebted countries as interest rates rise. The aim is to ensure that their debt yields do not deviate too much from other countries in the bloc, such as Germany. This year, the spread between Spain’s 10-year government bond yield and Germany’s has widened from 70 basis points to 113 basis points.

Reinvestment of proceeds from maturing bonds could be used to avoid this so-called fragmentation. The central bank has already stressed there is flexibility in its asset purchase programs, but investors are waiting to see if the bank will provide more details on how it might react to borrowing costs. divergent.

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