ECB: more work required to tame inflation

The European Central Bank (ECB) has raised all three of its key interest rates by a further 0.25%, bringing the deposit rate to 3.25%, the refinancing rate to 3.75% and the marginal lending rate to 4%. This is the first set of hikes that have not been half a percentage point in size, which would indicate that the ECB is close to ending its tightening of monetary policy.

However, president Christine Lagarde was at pains to emphasise at the policy decision press conference that “we [the ECB] are not pausing”, and that based on the staff projections in March, “…we believe that we have more ground to cover”. While being “data dependent”, it is clear that the Governing Council is not yet happy with the progress made in lowering inflation.

Lagarde also mentioned that past interest rate increases “…are being passed on forcefully”, and that the ECB’s recent Bank Lending Survey suggested that interest rates were now in restrictive territory. Banks have reported a fall in loan creation, owing to higher interest rates, but also lower demand in the economy.

The labour market continues to be resilient, as the latest unemployment rate estimate for March showed another fall to 6.5%. This was sighted as one of the upside risks to inflation. Should jobs growth continue to be stronger than expected, then demand and inflation pressures could persist.

Concerns over the stability of the banking sector were also raised, with reference to Silicon Valley Bank and Credit Suisse. While Lagarde sees a rise in tensions as presenting a downside risk, there was no immediate danger to act upon.

In addition to the rise in rates, the ECB also announced that it would be ending the re-investment of its assets held under the Asset Purchase Programme (APP) as of July. This is expected to shrink the ECB’s balance sheet by on average €25 billion per month, but would take 15 years to be fully wound down. Meanwhile, the Pandemic Emergency Purchase Programme (PEPP) would continue to be run down at a pace of €15 billion per month until next month. We expect an announcement in due course that would accelerate the run off in the PEPP from July onwards.

We expect the ECB to hike by another 0.25% in June, but the probability of further increases beyond then are smaller. If inflation continues to be more sticky, then a further rate rise in July could be on the cards. This would take policy into very restrictive territory, possibly even too restrictive, verging on a policy error.