Frankfurt When the European Central Bank (ECB) last raised interest rates more than eleven years ago, its president was still Jean-Claude Trichet. That move didn’t last long. Only a few months later, his successor Mario Draghi reversed this measure.
Since then, key interest rates in the euro area have continued to fall. The ECB will most likely end this trend at its meeting on Thursday.
However, the starting position for the central bank is more difficult than it has been for a long time. Inflation in the euro zone in June was at a historic high of 8.6 percent. That shouldn’t be the end: “We expect headline inflation to peak at over 10 percent in September,” says Roxane Spitznagel, economist at US fund manager Vanguard.
At the same time, however, there is a risk of a recession in the currency area, i.e. a shrinking economy. This danger arises especially when Russia suspends its gas supplies to Germany, Italy and other countries.
In addition, the yield spreads on the government bonds of highly indebted euro countries such as Italy have recently risen significantly since the ECB signaled imminent interest rate hikes. This increases the refinancing costs for the already ailing countries. Some economists, such as the head of the Munich Ifo Institute, Clemens Fuest, are therefore already warning of a new euro crisis.
In this environment, the ECB is faced with historic decisions. This does not only apply to their expected interest rate hike. The central bank also wants to present a new crisis instrument to support countries like Italy if necessary.
In view of the high level of inflation and great uncertainty, there is also the question of whether it will continue in the future to provide the markets with long-term guidance on its future monetary policy. The session comes down to these three key points:
1. How much is the ECB raising interest rates?
It is considered certain that the ECB will raise interest rates. The question is not whether it does so, but to what extent. The central bank had already declared at its council meeting in June that it wanted to raise interest rates by a quarter of a percentage point, i.e. 25 basis points, in July. In addition, it held out the prospect of a further, stronger increase for September. Central bank President Christine Lagarde reaffirmed these plans at the end of June.
However, there is also speculation about a stronger rate hike. In the past few weeks, several Council members such as the central bank governors from Latvia, Lithuania and Austria have spoken out in favor of this.
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 indicate flexibility here. In the Bundesbank, too, there is sympathy for such a more aggressive approach.
However, one argument against this is that the ECB made a relatively clear commitment to an interest rate hike of 25 basis points in advance. If it deviates from this, it could jeopardize its credibility in the markets.
“If the ECB raises interest rates by 50 basis points in July despite the explicit instructions for a 25 basis point hike, communication will be very difficult,” says Frederik Ducrozet, ECB expert at Swiss asset manager Pictet.
2. How does the ECB help highly indebted countries like Italy?
In the long term, the decision on the new crisis instrument could be even more important than the foreseeable interest rate hike. This should reduce the risk of a possible euro crisis.
The background is the significant increase in bond yields in recent months – especially in Italy. Since Lagarde announced the first interest rate hikes in the euro area for the summer in May, the risk premium (spread) compared to German Bunds has risen sharply in Italy, for example. At the same time, fears of a new euro crisis are growing.
The ECB wants to contain this with a new crisis instrument. Lagarde is likely to provide important details on Thursday.
The design of the crisis instrument is extremely controversial. Critics fear that this will undermine the incentives for sound budgetary policy and lead to new legal disputes over whether the central bank is engaged in prohibited state financing.
Proponents in the ECB, on the other hand, argue that the main priority is to ensure that monetary policy is effectively transmitted to the economy. A shoot-up in yields in Italy would be a hindrance, because this would drive up interest rates for companies and the economy as a whole. This in turn could make further rate hikes more difficult.
Vanguard economist Spitznagel assumes that the announcement of the crisis instrument could enable the ECB to raise interest rates more aggressively without causing a debt crisis in the euro area.
It is interesting to look at the details: For example, the questions of whether the ECB’s new instrument allows unlimited purchases of bonds, to what extent it will be linked to conditions and in which situations it should be used.
ECB board member Isabel Schnabel had previously stated that the central bank only wanted to react if yields in individual countries shoot up for speculative rather than fundamental reasons. How the ECB intends to distinguish between the two is open.
The current government crisis in Italy shows how difficult such a differentiation is. From the point of view of Pictet economist Ducrozet, the situation is exemplary for a situation of self-inflicted political uncertainty in which the ECB should not intervene.
The question of whether the instrument will be subject to conditions is highly relevant from the point of view of many economists. The International Banking Federation’s (IIF) chief economist, Robin Brooks, argues that these conditions are important to encourage highly indebted euro area countries to reform and discourage excessive use of the instrument.
3. Is the central bank sticking to its monetary policy orientation?
Another topic could also be the so-called forward guidance, i.e. the orientation about the future monetary policy of the central bank. Some experts have recently advocated abolishing them.
Forward guidance was introduced as an additional tool by the central bank when inflation in the euro area was very low and interest rates had reached the zero limit. The aim was to influence market expectations about future interest rates.
Currently, however, inflation is well above the level of two percent targeted by the ECB. From the point of view of critics, it is rather a hindrance in this environment to commit to a specific monetary policy course well in advance.
The ECB expert at the major French bank BNP Paribas in Frankfurt, Spyros Andreopoulos, therefore already sees a tendency at the ECB and other central banks to emphasize the data dependency of their decisions more strongly. “In an environment of high macroeconomic volatility, it is becoming increasingly difficult for central banks to guide markets, he says. “Attempts to do so could result in a loss of credibility if the central bank repeatedly violates its own guidance.”
More: Interview with Princeton economist Markus Brunnermeier: “Inflation requires aggressive action by the ECB”