ECB hikes rate by 75 bps and what are the implications

Just two months after the European Central Bank (ECB) had hiked rates by 50 bps, it effected another 75 basis points rate hike in its latest meeting on September 08th 2022. In July, the ECB had taken the benchmark rates from -0.50% to 0.00% and now the benchmark stands enhanced to 0.75%. This is the highest single shot spike in the ECB interest rates since the Euro was first introduced in the year 1999. The ECB had kept rates in negative territory since 2014 in a bid to spur spending and combat low inflation.

The 75 basis point interest rate rise to 0.75% was largely triggered by a surge in inflation in the Euro zone. Inflation is closing in on double digits and for the year 2022, the inflation is projected at 8.1% on an average, while the inflation is pegged at 5.5% for the year 2023. The inflation is expected to fall further to 2.3% in 2024, which would still be above its target median rate of interest of 2%. Although the quantum of the spike in interest rates was rather surprising, the markets had already factored in this hike in rates well in advance.

 
The problem today is largely driven by energy inflation while other items like food inflation and core inflation have also joined the chorus. In the Euro Zone, the problem today is of high inflation with the August inflation touching 9.1%. Energy prices in the EU region have soared since Russia’s invasion of Ukraine in February 2022. With Russia shutting off Nord Stream 1, the situation is only going to worsen in the Euro Zone. Price rises are now visible across food, clothing, cars, household appliances and services. 

The other worry is that too much of an anti-inflation stance can trigger a slowdown and a recession in the economies. GDP across the euro zone grew by just 0.8% in the June 2022 quarter. Analysts are assigning a high probability to consumer spending being squeezed and businesses struggling to pass on higher input costs. Ironically, the situation in the Euro Zone is largely akin to the US. Even in the Euro Zone, despite an extremely tight labour market, unemployment stands at a record low of 6.6%. So, inflation control may take longer.

To quote the ECB president, Christine Lagarde, “While we conclude that energy is the major source of inflation, along with the increase in food, we also have inflation spreading across a range of products and services where demand plays a role”. Lagarde also added the ECB had begun to normalize monetary policy from December 2021 when it had ended its asset purchase program. Lagarde is still confident of avoiding a recession with baseline outlook at 3.1% GDP growth for year 2022, 0.9% for year 2023 and an improved 1.9% for year 2024.

The takeaway for other countries like the US and Asia is that even the bastion of Europe has turned hawkish. That only leaves out a tentative Japan and a still dovish Chinese central bank. The RBI has already started its hawkish approach in tandem with the Fed to avoid the risk of monetary divergence. For now, it looks like the ratification from Europe would be an incentive for the US Fed to go ahead with another 75 bps rate hike in September and a rate hike of, perhaps, 50 bps in November. Beyond that, it would be largely macro data driven.