The European Central Bank headquarters, in Frankfurt, Germany, on March 16.HEIKO BECKER/Reuters
The European Central Bank raised its key interest rate to a record high of 4 per cent on Thursday but, with the euro zone economy in the doldrums, signalled that the hike, its 10th in a 14-month-long fight against inflation, was likely to be its last.
The central bank for the 20 countries that share the euro also raised its forecasts for inflation, which it now expects to come down more slowly towards its 2 per cent target over the next two years, while cutting those for economic growth.
That illustrated the dilemma ECB policy-makers had faced: prices are still rising at more than twice the target rate but with high borrowing costs and a downturn in China, overall economic activity is struggling.
Against this backdrop, the ECB sent a message that its rate hikes were probably at an end, prompting euro zone bond yields and the euro to fall and European shares to rise as investors bet that it would start cutting rates next year.
“Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target,” the ECB said.
That is now expected to happen more slowly than at the time of the ECB’s previous projections in June, with inflation seen at 5.6 per cent in 2023, 3.2 per cent in 2024 and 2.1 per cent in 2025.
Thursday’s 25-basis-point increase pushes the rate the ECB pays on bank deposits to 4.0 per cent, the highest level since the euro currency was launched in 1999.
When the ECB began tightening policy in July 2022, that rate was languishing at a record low of minus 0.5 per cent, meaning banks had to pay to park their cash securely at the central bank.
ECB President Christine Lagarde did not absolutely rule out a further hike if needed and said interest rates would have to remain at restrictive levels for some time.
“The focus is going to move, going forwards, to the duration, but that is not to say – because we can’t say that now – that we are at peak,” she told a news conference.
She acknowledged that some ECB board members did not even want to raise rates on Thursday but added: “There was a solid majority of governors to agree with the decision we have made.”
The absence of an explicit hint at further rate hikes or at plans to withdraw more cash from the banking system was seized upon by traders, who brought forward and ramped up their bets on rate cuts next year.
They now see a first cut as early as June, compared to September before Thursday’s decision, followed by two more by the end of 2024.
Lower market rates undo some of the effects of Thursday’s hike and show the market has some doubts about the ECB’s resolve to keep borrowing costs elevated for long.
“The ECB won’t be happy about this,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management.
Marco Brancolini, head of euro rates strategy at Nomura, said the ECB, like the U.S. Federal Reserve, will find it hard to convince markets it will not be cutting rates, particularly if growth forecasts for the euro zone continue to be downgraded.
One solution would be unconditional forward guidance, “but that’s a non-starter at this stage,” he added.
The Fed is widely expected to leave rates unchanged at its policy meeting next week, while the Bank of England is expected to hike, despite some repricing after the ECB decision.
Asked to comment on whether the ECB’s downgrading of its growth forecasts – with euro area growth this year now put at only 0.7 per cent – meant that a regional recession was now its base-case scenario, Lagarde insisted the slowdown was temporary.
“The recovery we had planned for the second half of 2023 has been pushed out over time,” she said. “We are confident that growth will pick up in 2024.”
The upgrade to the 2024 inflation estimate – which had been reported by Reuters earlier – likely played a role in discussions as policy-makers weighed the risk that inflation, currently still above 5 per cent, would get stuck at a high level.