ECB gets priority right with interest rate hike

In July, when the European Central Bank shocked financial markets with a historic 50 basis-point interest rate hike — more than it had signalled —I concluded it would need to dish out many more surprises over the next few months to fight runaway inflation, which has soared to almost 5 times its 2% target.

Freshly free from the fetters of forward guidance, which meant it broadly needed to keep the financial markets abreast with its rate trajectory, the bank led by Christine Lagarde didn’t disappoint on Thursday. It executed an unprecedented 0.75% rate hike, overlooking concerns from the doves who have been advocating a more gradual tightening of the money taps, citing the worsening economic outlook.

The massive hike shows that the central bank which has been slow to the rate-hike party is eager to make up for the lost time and help tame inflation that’s eating up household savings and hurting businesses.

The bank seems to be in a hurry to transition from its still highly accommodative monetary policy to a more normal interest rate regime before the eurozone slips into a recession and ties the bank’s hands. As I wrote here, the ECB is rightly choosing to inflict pain on the economy by increasing borrowing costs to dampen demand now when there is only a risk of recession than doing so during an actual recession.

Inflation in the eurozone climbed to 9.1% in August on the year, mainly driven by a rise in energy and food prices. While it’s true that the ECB can’t pump more gas to make up for the loss of Russian gas and help bring down prices, but then it’s not just energy pushing up inflation.

Excluding food and fuel, inflation soared to 5.5% last month as services costs and prices of non-energy industrial goods rose, underscoring that inflation has become much more persistent and broad-based. While a lot of that has to do with supply chain disruptions caused by the pandemic, the war in Ukraine and a devastating drought in Europe, soaring demand for services, partly thanks to the ECB’s ultra-loose monetary policy, also has had a role to play. Services and non-energy industrial goods are two of the largest components of inflation in the euro area with a total weight of nearly 70%.

The ECB would also have its eyes on the job market where a scarcity of workers is threatening to drive up wages even in the event of a slowdown. This could set off a so-called wage-price spiral that keeps inflation high and can prove to be extremely difficult to break.

Then there is the euro, which is struggling to hold its ground against the dollar. The sinking euro has added to the miseries of European households and businesses by making imports, which are mostly denominated in dollars, more expensive. An aggressive rate-hike cycle will support the euro, which has in part suffered as a result of the wide gap between interest rates in the US and the eurozone resulting from the ECB’s past inaction.

The ECB has seen its reputation tarnished in recent years when it struggled to push up inflation to its target of 2% and more recently when it chose to recklessly stay put with negative interest rates even as inflation ran amok and its peers responded with outsized rate hikes.

It’s once again walking a tightrope with its credibility at stake. An aggressive tightening will exacerbate the feared downturn in the eurozone, but the price of gradualism would be much worse as it could drive up long-term inflation expectations and push the common currency area into a recession much deeper than is being feared now.

The 0.75% hike indicates that the ECB is prioritising its price stability mandate, perhaps in the hope that it can redeem itself once inflation starts retreating. That would take some time. In the meantime, governments have their own role to play.