ECB raises rates to nip war-led inflation in the bud

[FRANKFURT] The European Central Bank raised interest rates for the first time in nearly three years on Thursday (Jun 11) in the hope of curbing inflation before a surge in energy costs triggered by the Iran war spreads more broadly across the euro zone economy.

The well-telegraphed move comes as inflation in the 21-country currency bloc is already above 3 per cent, well in excess of the ECB’s 2 per cent target, and economic growth is very weak - a backdrop that has economists split over the case for tighter policy.

ECB policymakers, some of whom had already pushed for action in April, nonetheless pressed ahead with the decision, which was accompanied by higher projections for inflation this year and the next.

“The war in the Middle East is generating inflation pressures, and the decision to raise rates is robust across a range of scenarios mapping out how the shock might evolve and affect the medium-term outlook for the euro area,” the ECB said in a press release.

Thursday’s hike is the first since September 2023 and takes the ECB’s benchmark deposit rate to 2.25 per cent from 2 per cent.

Economists had widely expected the move, saying it was mainly designed to keep a lid on inflation expectations and safeguard the ECB’s credibility after it was slow to react to a post-pandemic inflation spike in 2022.

Several ECB watchers had characterised it as an “insurance hike” - a precautionary step that could be reversed if price pressures fade.

As usual, the ECB did not commit to any future move, sticking to its long-standing line that decisions will be made at each meeting depending on incoming data. Financial markets expect another two hikes over the coming year, with the next seen as soon as September.

Inflation projections revised up

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ECB set for ‘insurance hike’ as Iran war fans euro zone inflation

The ECB’s new baseline projections for inflation put it at 3 per cent this year, 2.3 per cent in 2027 and 2 per cent in 2028, bringing them closer to the “adverse” scenario the bank had published in March.

“The outlook remains uncertain, with upside risks for inflation and downside risks for economic growth. The full implications of the war for medium-term inflation and growth will depend on the intensity and duration of the energy price shock, as well as the scale of its indirect and second-round effects,” the ECB said.

Investor attention will now shift to ECB President Christine Lagarde’s press conference at 1245 GMT and the bank’s new adverse and severe scenarios, which will be published thereafter.

“We expect President Lagarde to indicate that the outlook for the euro-zone economy is moving more in line with their adverse scenario, which requires measured policy tightening,” Lee Hardman, a senior analyst at broker MUFG, said.

Consumers, companies and financial investors have revised their own views about price hikes, although medium-term expectations remain close to the ECB target and far from their levels following Russia’s 2022 invasion of Ukraine.

“Two hikes this year thus looks like a minimum,” Anatoli Annenkov at Societe Generale said. “Markets are likely to start pricing in the next hike in July... but we still think a majority of governors would prefer to wait for more data and new forecasts in September.”

A policy mistake?

Not all economists are convinced that a hike is justified: some warn that the ECB risks tightening into an economy that is already paying a high price for the conflict in Iran.

Paul Donovan, chief economist at UBS Global Wealth Management, said the ECB was committing an “error” and was stuck in an “unhelpful 2022 mindset”, referring to the inflation rebound that followed Covid-19 lockdowns.

A Reuters analysis of earnings call transcripts by euro zone companies showed just 40 per cent of those outside the financial sector had raised prices or were planning to do so, roughly half the share seen in 2022 as the Ukraine war pushed up energy prices.

Berenberg’s Holger Schmieding also called it “a policy mistake” given the stagnant labour market and weak consumer demand.

“Amid the ongoing destruction of demand, the inevitable temporary surge in prices ... seems unlikely to turn into a protracted inflation problem that would need to be addressed by higher rates,” he wrote in a note. But the ECB has sharpened its messaging in support of tighter policy.

Chief economist Philip Lane - typically seen as an inflation “dove” - has said the Iran-related shock may be broader in scope than the Ukraine crisis, as it affects global energy markets rather than primarily Europe. REUTERS