The European Central Bank will raise interest rates next month for the first time in 11 years and add another hike in September, catching up with other central banks worldwide as they pivot from supporting the economy during the COVID-19 pandemic to squelching soaring inflation.
The surprise move Thursday marks a turning point after years of extremely low interest rates but faces risks from weakening prospects for economic growth. Russia’s war in Ukraine has sent shock waves through the global economy, particularly as energy prices have soared and clobbered Europe, which relies on Russian oil and natural gas.
“Russia’s unjustified aggression towards Ukraine continues to weigh on the economy in Europe and beyond,” bank President Christine Lagarde told reporters. The war is “disrupting trade, is leading to shortages of materials and is contributing to high energy and commodity prices.”
The bank’s 25-member monetary policy council, which met in Amsterdam, said inflation had become a “major challenge” and that those forces had “broadened and intensified” in the 19 countries that use the euro currency. Consumer prices rose by a record 8.1% in May. The bank’s target is 2%.
The ECB will first end its bond purchases that buoy the economy and then raise rates by a quarter-point in July. It left open the possibility that it would make a more drastic, half-percentage-point increase in September, saying that if the inflation outlook persists or deteriorates, “a larger increment will be appropriate.”
The U.S. Federal Reserve raised its key rate by a half-point May 4 and has held out the prospect of more of those larger increases. The Bank of England has approved rate hikes four times since December.
The bar to a half-point hike in September “has been set very low,” said Marc Ostwald, chief economist and global strategist at ADM Investor Services International.
How far the bank will go after that is harder to tell, said Carsten Brzeski, global head of macro at ING bank.
“Simply put, the ECB just announced the end of a long era,” Brzeski said. “Whether this will also be the start of a new era of continuously rising interest rates, however, is still far from certain.”
The prospect of rapid increases has sent shudders through stock markets, as higher rates would raise the returns on less risky alternatives to stocks and can make credit more expensive for businesses. Lagarde said, however, that the path of increases would be “gradual but sustained” after September.
“High inflation is a major challenge for all of us,” the bank said in a policy statement. “The governing council will make sure that inflation returns to its 2% target over the medium term.”
By raising its benchmarks, the bank can influence what financial institutions, companies, consumers and governments have to pay to borrow the money they need. So higher rates can help cool off an overheating economy.
But higher rates can also weigh on economic growth, making the ECB’s job a delicate balance between snuffing out high inflation and not blunting economic activity.
The ECB slashed its growth projection for this year to 2.8% from 3.7%. It raised its outlook for inflation, saying price increases would average 6.8% this year, up from 5.1% in its March forecast.
The bank also increased its crucial inflation forecast for 2024 — to 2.1% from 1.9%. That is significant because it indicates the bank sees inflation as above target for several years, a strong argument for more rate increases.
The euro’s exchange rate to the dollar jumped by almost a half-cent, to $1.076, after the decision. Higher rates can increase demand for investments denominated in a currency, boosting its exchange rate. The sudden jump indicates the bank had gone further than expected in announcing rate rises.
An ECB’s move to attack inflation has raised concerns about the impact of higher interest rates on heavily indebted governments, most notably Italy. The bank announced no new support measures that could help such countries, saying only that it would respond with flexibility if some parts of the eurozone were facing excessive borrowing costs.
The rate hikes end an era of persistently low rates that started during the global financial crisis, which broke out in 2008. The increases will start from record lows of zero for the ECB’s lending rate to banks and minus 0.5% on overnight deposits from banks.