Frankfurt At its meeting in June, the Governing Council of the European Central Bank (ECB) discussed whether the fight against inflation requires higher interest rate hikes than previously announced. “A number of members expressed an initial preference to keep the door open for a larger hike at the July meeting,” read minutes of the June 8-9 rate meeting released by the ECB on Thursday.
The Governing Council must retain discretion to adjust the size of the interest rate hike if new information materially affecting the medium-term inflation outlook becomes available for the July meeting.
At its interest rate meeting in June, the euro central bank announced that it would be abandoning years of ultra-loose monetary policy due to the ongoing surge in inflation in the euro area. Finally, it was decided to hold out the prospect of the first rate hike in eleven years for July. The most important interest rates are then to be raised by 0.25 percentage points each. For the meeting in September, she also signaled a possibly even stronger increase.
A number of experts fear that the ECB is taking too hesitant steps in its fight against inflation. “The ECB should raise interest rates by 50 basis points,” Mohamed El-Erian, prominent economist and economic adviser to the insurer Allianz, demanded in an interview with the Handelsblatt. In June, inflation in the euro area rose faster than expected to a new record high of 8.6 percent.
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>> Read here: Mohamed El-Erian fears these three scenarios on the markets
The Governing Council held an extraordinary meeting just six days after the regular meeting in June. The central bank was in a state of alarm because the yield differentials – known as spreads – on government bonds in the euro countries had widened sharply.
The currency guardians therefore want to introduce a new instrument that is intended to prevent a new euro crisis. Yields on government bonds from the euro countries rose sharply after the announced turnaround in interest rates. The yields of highly indebted euro countries increased particularly significantly, which means higher financing costs for them.
French central bank governor Francois Villeroy de Galhau said on Wednesday that the new monetary policy tool would be powerful: “I have no doubt that we will deploy an effective tool to protect against unjustified fragmentation,” the ECB Governing Council member told Les Echos newspaper “. It’s not about helping this or that government out of political considerations. “For monetary policy to be effective, it must reach all economic actors in the euro area,” he said.
However, there are different opinions within the ECB on the fight against an imminent fragmentation of the monetary union. Bundesbank President Joachim Nagel is skeptical about attempts to curb risk premiums for countries with higher debt. “It is next to impossible to determine with certainty in real-time whether spread widening is fundamentally warranted. You quickly get into dangerous waters here,” Nagel warned earlier this week.
>> Read here: Bundesbank President warns against ECB aid for indebted euro countries
According to information from the Bloomberg news agency, the new tool already has a name. The project runs under the title “Transmission Protection Mechanism”, which can still change. There is still a lot of work ahead of the ECB and it is not certain that the tool will be ready for use at the next interest rate meeting on July 21.
Inflation expectations are falling
The announced turnaround in monetary policy is now beginning to have an effect. Long-term inflation expectations on the markets have fallen significantly. This is reflected in the lower yield differential between 10-year conventional bonds and 10-year inflation-linked bonds. At the beginning of May, the gap was just under three percent, but it is now just over two percent.
As a result, inflation expectations have also fallen back to the level of early March. The inflation expectations measured in this way are called the break-even yield. This ratio indicates how high the inflation rate would have to be over a certain period of time for a bond whose interest and repayment offer compensation for inflation to yield the same return as a bond bearing nominal interest.
The inflation measure preferred by the ECB is even more complex, but here, too, inflation expectations have fallen significantly from 2.5 percent in May to just over two percent recently. The ECB looks at the “five-year-five-year-forward” barometer on the derivatives markets, i.e. the five-year expectations for inflation over the next five years.
This value is currently 2.04 percent. In concrete terms, this means that investors expect inflation to average a good two percent between 2027 and 2032. This means that inflation would be around the level that the ECB is aiming for as the optimum for the economy.
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