Central bank raises interest rates for the first time since 2011

In addition, the ECB decided on a new crisis instrument to help highly indebted countries like Italy. The background to this is that the yield spreads in individual countries have risen sharply since interest rate hikes were indicated. This had raised concerns about a new euro crisis. The central bank wants to curb this risk with the new instrument.

The instrument is intended to enable the ECB to buy bonds from individual countries in a targeted manner. However, this should only be done if the aim is to “counteract unjustified, disorderly market dynamics that pose a serious threat to the transmission of monetary policy in the euro area,” the ECB said. However, she has not yet given precise criteria for when this is the case. The central bank will announce further details in a separate statement at 3:45 p.m.

For the central bank, both decisions mark a historic turning point. The central bank is ending a more than decade-long phase of sustained interest rate cuts deep into negative territory.

The crisis instrument that was also adopted could in turn stabilize the monetary union, but also lead to new legal disputes as to whether the central bank is engaged in prohibited state financing.

In the run-up, an interest rate step of only 0.25 percentage points had actually been expected for a long time. At its council meeting in June, the central bank declared that it wanted to raise interest rates by a quarter of a percentage point, i.e. 25 basis points, in July. Central bank President Christine Lagarde reaffirmed these plans at the end of June.

Some experts, such as Frederik Ducrozet from the Swiss asset manager Pictet, had therefore argued that a step of 50 basis points could weaken the ECB’s credibility with investors and would make it difficult to communicate.

In the past few weeks, however, some ECB council members had already positioned themselves for a stronger rate hike in July, such as the central bank governors from Latvia, Lithuania and Austria. The head of the Latvian central bank, Martins Kazaks, declared at the end of June that, from his point of view, a weighted forward increase in interest rates could make sense, including a larger rate hike in July. Statements by the governors of the Belgian and Dutch central banks also indicated flexibility here. In the Bundesbank, too, there was sympathy for such a more aggressive approach.

Proponents of a sharp rise in interest rates argue that a clear signal in the fight against inflation is needed to prevent a wage-price spiral in which both factors boost each other.

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There is also some hope that higher interest rates will support the exchange rate of the euro and thus also dampen the risk of inflation. The euro had recently lost significantly in value compared to the US dollar and had fallen below par with the US currency.

This in turn tends to increase inflationary pressures because many imports such as oil and other commodities are priced in dollars. This means that if the euro exchange rate falls, import prices rise, which further increases the price pressure.

ECB announces end of forward guidance

The central bank also announced the end of the so-called forward guidance. This means orientation on future monetary policy. The ECB introduced this additional tool when interest rates hit the zero limit. The aim was to influence market expectations about future interest rates.

Going forward, however, the Council could “move to an approach where interest rate decisions are taken on a session-by-meeting basis,” the statement said on Thursday. Nevertheless, the central bank held out the prospect of a further increase in interest rates at the coming meetings. This will be “reasonable”.

What the new instrument of the ECB means

In the long term, the ECB’s new crisis instrument could be even more important than the interest rate hike. In an emergency, the central bank can use it to buy unlimited amounts of bonds from individual euro countries. Yields on bonds in the euro zone have risen significantly since mid-May after the ECB signaled that interest rates would rise soon.

The movement was particularly pronounced for Italian government bonds: the yield rose from below 2.9 percent in May to almost 4.3 percent. The Governing Council then met for a special meeting on June 15 and announced the new crisis instrument.

Proponents argue that this will make it easier for the ECB to raise interest rates across the board. If yields in countries like Italy or Spain rise much more sharply than in Germany, for example, as a result of tightening monetary policy, it could become more difficult to push through interest rate hikes. Rising yields on government bonds are also driving up financing costs for companies in the respective country.

However, the project has become even more explosive due to the current government crisis in Italy. After Italian Prime Minister Mario Draghi announced his resignation on Thursday, new elections could now be held there in the fall. The ultra-right Fratelli d’Italia is currently in the lead in polls. Should a new government decide to spend expensively, this could further weaken investor confidence and put the ECB under pressure.

Governing Board member Isabel Schnabel had previously stated that the central bank would only react if yields in individual countries shoot up for speculative rather than fundamental reasons. From the point of view of many economists, this does not apply to a government crisis.

“A self-inflicted political crisis in Italy is the textbook case of a situation where the ECB should not intervene,” says Frederik Ducrozet, ECB expert at Swiss asset manager Pictet. In any case, it is difficult to distinguish between developments driven by speculation and fundamental reasons.

Bundesbank President Nagel had also expressed doubts as to whether the two factors could be clearly separated. “It is next to impossible to determine with certainty in real-time whether spread widening is fundamentally warranted. It’s easy to get into dangerous waters here,” he warned. He also argued that it was entirely plausible that the risk premiums in highly indebted member states would rise more sharply because of the announced turnaround in interest rates. “As risk-free interest rates rise, market participants review their risk appetite.”

>> Read here: “Dangerous waters” – Bundesbank President warns of ECB aid for indebted euro countries

The new instrument could also lead to new legal disputes as to whether the central bank is not engaged in prohibited state financing, which it is forbidden under its statutes. Commerzbank economist Michael Schubert saw the ECB facing a dilemma before the decision on Thursday. From his point of view, it makes itself all the more legally vulnerable the more effectively it designs the program by allowing purchases under relaxed conditions or by potentially intervening indefinitely.

The prerequisite for using the new instrument should be that the affected country complies with the conditions of the Corona reconstruction fund. This is considered a comparatively low hurdle compared to the earlier bond purchase program known under the abbreviation OMT and aid from the European rescue fund ESM.

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