The European Central Bank logo outside its headquarters in Frankfurt, Germany on March 16.HEIKO BECKER/Reuters
The European Central Bank will make one of the toughest decisions in its 25-year history on Thursday as it considers whether to raise interest rates for a 10th consecutive time to curb inflation.
The ECB, which conducts monetary policy for the 20 member states of the euro zone, faces a delicate situation. The economy has slowed to a crawl, yet inflation is still far too high for comfort.
As central bankers meet this week in Frankfurt, Germany, the overarching question is whether rates are sufficiently restrictive to bring inflation back to the ECB’s two-per-cent target, or whether another hike is needed.
Analysts and investors are roughly split over the next move, with some calling it a coin-toss outcome. And while policy makers have broadly supported the path of interest rates to date, there are growing signs of dissent – particularly as some countries suffer more in a high-rate environment.
European Central Bank policy-makers say September rate decision still up in the air
“This is a central bank that is almost like a circus at times,” said Simon Harvey, head of FX analysis at Monex Europe, a foreign-exchange company. “We haven’t really seen it over the past year, because the conditions warranted a kind of a cohesion and alignment behind a unified course of tackling inflation. But now you are starting to see the cracks appear.”
From a rates perspective, the past year has been a whirlwind in Europe. Since July, 2022, the ECB has raised its key interest rates by 425 basis points. (A basis point is 1/100th of a percentage point.) The deposit rate, which had been in negative territory since 2014, is now at 3.75 per cent, matching a record high.
The impact of that tightening is apparent. In Germany, building permits for apartments plunged by 27 per cent in the first half of 2023, compared to the same period a year earlier. Factory output and orders have fallen sharply across the region, and bank lending has tailed off. The euro zone grew just 0.1 per cent in the second quarter.
At the same time, the labour market is a source of strength. The unemployment rate has held at an historic low of 6.4 per cent. ECB president Christine Lagarde has credited “labour hoarding” – the idea that companies are hanging on to workers, because it was so tough to find them – for some of the resilience.
“Employment has been really strong,” said Andrew Kenningham, chief Europe economist at Capital Economics. “That’s been a theme globally – that the economy’s softened, but the labour market hasn’t.”
The inflation data are complicated. After peaking at 10.6 per cent last fall, the annual rate of consumer price growth has ebbed to 5.3 per cent. But much of the progress is because of the fading impact of commodity costs, which spiked after Russia’s invasion of Ukraine in early 2022.
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Core inflation, by contrast, is proving stickier. After excluding energy and food costs, the annual pace of inflation was 5.3 per cent in August, according to a preliminary estimate. That’s not much better than a peak rate of 5.7 per cent in March. Services inflation is similarly high. And because the labour market is so tight, strong wage growth could provide a tailwind to price growth.
“Generally across the euro zone, there is a long way to go in the inflation fight,” Mr. Harvey said.
In their public communications, ECB policy makers have mostly avoided leaning toward either rate decision. “We might hike and we might hold, and what is decided in September is not definitive,” Ms. Lagarde said in July.
But some central bankers are more explicit in their views. The head of Slovakia’s central bank, who is part of the ECB’s governing council, recently called for a final hike on Thursday.
Others skew more dovish. “In the monetary dimension, the risk of ‘overdoing’ [it] is starting to materialize,” Mário Centeno, the Governor of the Bank of Portugal, wrote in a report this month.
The political arena is undoubtedly louder. Elected officials in Spain and Italy have openly criticized the ECB over its rate hikes or questioned the need for further action. “Does Lagarde have a variable-rate mortgage? Does she know how much payments are rising?” asked Italy’s Deputy Prime Minister, Matteo Salvini, in remarks translated from an Italian news outlet.
The discord is likely to ramp up in the coming months, given that central bankers have stressed that it’s far too early to talk rate cuts. With rates staying higher for longer, that should put more pressure on debt-addled households and governments. Meanwhile, economic conditions are deteriorating in the currency union.
Stubborn euro zone inflation fails to settle ECB rate debate
Still, that grim backdrop shouldn’t distract from the task of bringing inflation to heel, said Mr. Kenningham, who expects the ECB to raise interest rates by a further 25 basis points this week. In a report, he collected the recent comments of Europe’s central bankers, finding they leaned hawkish – thus supporting another rate hike.
“There have been some very downbeat data on economic activity. But at the end of the day, the ECB’s mandate is to control inflation and not worry too much about activity,” he said.
Mr. Harvey of Monex Europe also expects another hike. “I think they’d rather take that insurance of 25 basis points, as opposed to holding and then having to resume later down the line when conditions are much worse.”
Even so, the next move is anything but a done deal.
“There’s pretty much an argument on either side of this,” Mr. Harvey said. “I think the main takeaway is that this isn’t going to be a unanimous decision.”