European central bank surprises markets with half-point rate hike

In a statement, the bank’s governing council said it acted based on an “updated assessment of inflation risks” and said further such actions were expected.

Today’s move brings Europe’s main deposit rate to zero after an extraordinary eight years in negative territory and comes as the European currency union confronts pandemic, war and political upheaval.

On Thursday, Italy, the euro area’s third-largest economy, remained mired in political crisis as Prime Minister Mario Draghi resigned following the collapse of his governing coalition.

Speaking to reporters after the decision was made public, ECB President Christine Lagarde said an unanticipated deterioration in the inflation outlook warranted the larger rate increase. Inflation in the 19-nation euro zone reached 8.6 percent last month, the highest level in decades, and up from 8.1 percent in May.

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“We must bring inflation down. … It’s time to deliver,” she said.

Natural gas prices in Europe have more than doubled since Russia’s Feb. 24 invasion of Ukraine, increasing costs for businesses and households on the continent and raising the specter of a prolonged bout of inflation.

“Price pressures are spreading across more and more sectors,” Lagarde said. “We expect inflation to remain undesirably high for some time.”

ECB officials’ hopes for corralling inflation rest on an easing of energy costs and supply bottlenecks along with the effects of higher interest rates, Lagarde said. Officials will decide on additional rate hikes on a “meeting by meeting” basis, depending upon incoming economic data.

The ECB is scheduled to next meet on Sept. 8.

European monetary officials are behind the Federal Reserve, which began raising interest rates in March and already has increased them three times, by a total of 1.5 percentage points.

Like its U.S. counterpart, the ECB is struggling to rein in rising prices without driving the economy into recession. The challenge is especially acute in Europe, where inflation is largely driven by energy costs that rate hikes can do little to address.

The ECB’s baseline forecast does not foresee a recession either this year or in 2023, though Lagarde acknowledged that growth is slowing and the outlook is especially uncertain.

ECB leaders also announced agreement Thursday on a new monetary policy tool designed to prevent financial fragmentation of the euro bloc.

The 25-member Governing Council agreed unanimously to establish a new “Transmission Protection Instrument” designed to transmit monetary policy decisions smoothly across all euro-using nations.

By activating the new instrument, the ECB could buy government bonds issued by euro-zone members. The aim would be to “counter unwarranted, disorderly market dynamics” that threaten to splinter the currency union.

Lagarde declined to say whether the TPI could lead to central bank purchases of Italian bonds, whose yields have soared amid a weeks-long political crisis that is expected to lead to early parliamentary elections.

As doubts have grown over Italy’s future, investors have demanded higher interest rates on Italian government bonds. The Italian government now must pay 3.5 percent to borrow money from investors for 10 years, more than 2 full percentage points higher than Germany.

Even as the bank moved to battle rising prices, many analysts were warning that Europe’s weakening economy would likely force an early end to the rate hikes.

The euro this month hit parity with the dollar, trading at an even 1-for-1 rate for the first time in two decades.

“There will be no hiking cycle for the ECB. The Euro zone is going into recession. The coming [economic] contraction will make inflation old news,” Robin Brooks, chief economist for the Institute of International Finance, said on Twitter.

The banking system in the euro area already has begun tightening credit.

European banks became pickier about the borrowers they granted loans in the last three months, according to the ECB’s Bank Lending Survey released this week. Business demand for credit remains strong, but it is driven by a need for working capital to cope with rising costs rather than funds for new investment, said the quarterly survey of 153 institutions.

Looking ahead, European banks said they anticipate “a moderate net decline in demand for loans,” the ECB reported.