ECB turns hawkish and delivers its largest ever interest rate rise

The European Central Bank (ECB) has hiked all three of its key interest rates by 75 basis points, taking the refinancing rate to 1.25%. Its deposit rate, which had been negative until the last meeting, will now rise to 0.75%. The increase is the largest such move in a single meeting in the ECB’s history and marks a noticeable change to more hawkish sentiment.

Although the ECB has been slowly unwinding its monetary stimulus since December, by ending its QE purchases along with other measures, the language used at its previous policy setting meeting in July suggested that it had started to front-load rate rises, and that further increases could be smaller. However, at today’s press conference, ECB president Christine Lagarde continued to signal further frontloading, and said that the ECB was some way away from reaching an interest rate level consistent with returning inflation back to target.

The ECB’s new projections paint a gloomy outlook. Inflation is forecast to average 8.1% in 2022 (increased from 6.8%), 5.5% in 2023 (previously 3.5%) and 2.3% in 2024 (previously 2.1%). The ECB’s GDP growth forecast has been cut for 2023 to 0.9% from 2.1%, and to 1.9% for 2024 (previously 2.1%).

The ECB sights four factors for the slowdown in growth in the forecast.

  • Higher energy prices are likely to reduce household spending power and demand, while production is also likely to be hit by higher costs.
  • The current rebound in post-pandemic spending, especially on contact services, is likely to ease back to more normal levels.
  • Global growth is weakening, which is likely to reduce growth in exports. At the same time, the depreciation of the euro has reduced the domestic value of exports relative to imports.
  • Uncertainty is high and both household and businesses confidence is falling sharply.

Despite these risks, the ECB is not forecasting a recession. The forecast has the economy stagnating over the winter period, before returning to growth in spring 2023.

In contrast, the Schroders forecast is more negative and includes a recession, but has a lower inflation profile. Since the Schroders forecast was published, energy prices have risen further owing to Russia halting most of its gas exports to Europe. But this would lead to a further downward revision to the growth forecast.

Looking ahead, the language used by Lagarde at the press conference suggests further large increases for the rest of the year. Our previous forecast had the main refinancing rate rising to 1.5% then remaining there until the end of the forecast.

However, rising inflation risks and the more hawkish turn in language from the ECB suggests that rates could rise much further – perhaps up to 3%. If the economy goes into recession, then the ECB may stop its hikes sooner, which is our base case, but for now, the message is clear that further urgent tightening is required to reduce the risk of inflation becoming embedded in the economy.

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