The European Central Bank raised interest rates by half a percentage point – its first increase in more than a decade – while vowing to prevent rising borrowing costs from triggering a eurozone debt crisis amid political turmoil in Italy.
The central bank raised interest rates twice as much as it said it would do just last month, ending eight years of negative rates by pushing the deposit rate to zero.
Christine Lagarde, the president of the ECB, said on Thursday afternoon that it was “time to act” after eurozone inflation hit a new record of 8.6% in the year to June, more than four times the central bank’s 2% target.
Policymakers simultaneously agreed on a new bond-buying program aimed at countering a disorderly spike in the cost of borrowing for the region’s more vulnerable governments. “The ECB is capable of getting big,” Lagarde said, later adding: “We prefer not to use [the new programme]but if we have to use it, we won’t hesitate.”
The ECB had to walk the fine line between responding to inflation and avoiding dragging the region into recession. The bloc has already been hit by a spike in energy and food prices following Russia’s invasion of Ukraine, a slowdown in business activity and a drop in consumer confidence to record lows. The ECB’s decision came hours after Mario Draghi resigned as Italy’s prime minister. His planned departure is expected to trigger a snap election this year.
Krishna Guha, head of central bank policy and strategy at US investment bank Evercore, said before Thursday’s decision: “The combination of a looming giant stagflationary shock from armed Russian natural gas and a political crisis in Italy is about as close to a perfect storm as it gets let’s imagine for the ECB.’
The ECB has been slower than most central banks to react to rising inflation and lags behind the US Federal Reserve, which is expected to raise interest rates by at least 75 basis points next week, matching a move of a similar size last month.
The euro initially jumped after the ECB announcement, but later pared its gains against the dollar to $1,019. Carsten Brzeski, head of macro research at Dutch bank ING, said investors were accepting the possibility of the ECB raising rates less than expected in the future after it “weakened its guidance from before” by moving to a “meeting-by-meeting approach” to decisions for interest rate’.
Lagarde said discussions within the bank’s governing board had evolved around a trade-off between the need to tackle inflationary pressures with bolder interest rate hikes while designing a new bond-buying scheme to prevent spreads from widening in the Eurozone for reasons other than those justified on economic grounds.
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The amount of bond purchases under the new program, the “transmission protection instrument” or TPI, “had no limits.” Lagarde said. It aimed to ensure that the central bank’s monetary policy stance had the desired impact across the euro area.
Although support for the program was unanimous, there was only “consensus” on the scale of the rate increase.
The political turmoil in Rome has raised concerns about how rising interest rates will affect the sustainability of Italy’s public debt at 150 percent of gross domestic product.
Italian debt sold off on Thursday, with the yield on the country’s 10-year government bond jumping 0.24 percentage points to 3.6% after Draghi’s national unity coalition collapsed and the ECB raised rates. The fall in bond prices in Rome meant the spread between Italian and German benchmark yields – a closely watched gauge of market stress – rose to 2.3 percentage points, reflecting a widening of about 0.3 percentage points in just two days.
The last time the ECB raised interest rates, under then-president Jean-Claude Trichet, it was forced to reverse the move a few months later as the eurozone was gripped by a sovereign debt crisis.
The central bank said rates would rise further at future meetings, adding: “Today’s front-loading of the exit from negative interest rates allows the Governing Council to transition to a meeting-by-meeting approach to interest rate decisions.”
Lagarde said there remained “upside risks” to inflation – code for the possibility that price pressures may remain stronger than the ECB’s forecasts suggest.
The ECB’s interest rate on its main refinancing operations rose from zero to 0.5 percent, and the interest rate on its marginal lending facility increased from 0.25 percent to 0.75 percent.
The last time it raised rates by half a percentage point was in June 2000, just over a year after the introduction of the euro.
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