The European Central Bank has surprised markets by raising interest rates by 25 basis points more than expected on Thursday. Library picture: Christine Lagarde, president of the European Central Bank, is seen speaking at a conference in Frankfurt, 22 November 2019. Photo credit: European Central Bank

The European Central Bank has surprised markets by raising interest rates by 25 basis points more than expected on Thursday. Library picture: Christine Lagarde, president of the European Central Bank, is seen speaking at a conference in Frankfurt, 22 November 2019. Photo credit: European Central Bank

So it will be 0.50%. For its first rate hike in 10 years, the European Central Bank has chosen the most “vigorous” voice. To avoid tensions on the debt of peripheral countries, the ECB has presented a new monetary policy tool, the TPI.

The ECB had announced that it would raise its key interest rates at the end of last year. According to the scenario adopted at the time, the central bank was to raise its rates by 25 basis points (bp) this Thursday and then by 50bp in September.  This “gradual” approach had been called into question in recent days. Christine Lagarde, the ECB chair, said publicly that there were now “clearly conditions in which gradualness would not be appropriate”.

Thursday’s increase brought the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility down to 0.50%, 0.75% and 0.00% respectively, with effect from 27 July 2022. This is not yet a tightening, but a normalisation. The tightening will start in September, when the 50 basis point increase announced in June comes into effect. That is, if the initial scenario is followed.

It is an open question, because inflation continues to rise. In June it reached its highest level ever at +8.6% over one year, according to Eurostat. This increase is mainly fuelled by the rise in energy prices (+ 41.9%), food prices (+ 8.9%) and services prices (+ 3.4%). At the same time, the euro fell against the dollar to reach parity. Since the beginning of the year, the European currency has lost 10% against the greenback. The dollar is benefiting from the rise in US interest rates. A rise that comes at a bad time when oil prices--which are traded in dollars--remain at their highest.

“The Governing Council’s future interest rate path will continue to be data dependent and will contribute to the achievement of its inflation objective of 2% over the medium term. As part of its policy normalisation, the Governing Council will assess options for remunerating excess liquidity,” Lagarde said on 21 July.

TPI unveiled

This increase weakens the most indebted European countries, led by Italy. Italy has just Mario Draghi, who was Lagarde’s predecessor at the head of the ECB from 2011 to 2019.

To avoid a new debt crisis, the ECB has begun to define the contours of the anti-fragmentation tool intended to help the most fragile eurozone countries, called the Transmission Protection Instrument. The TPI is “necessary to promote effective transmission of monetary policy” and will allow the ECB to come to the rescue of a member state by buying its bonds massively, if its sovereign rate is attacked on the markets for “illegitimate” reasons.

The ECB said in an announcement: “The TPI will be an addition to the Governing Council’s toolkit and can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area. The scale of TPI purchases depends on the severity of the risks facing policy transmission. Purchases are not restricted ex ante. By safeguarding the transmission mechanism, the TPI will allow the Governing Council to more effectively deliver on its price stability mandate.” 

That said, the flexibility of reinvesting maturing redemptions into the Pandemic Emergency Purchase Programme portfolio remains the first line of defence to counter the risks to the transmission mechanism from the pandemic.

Originally published in French by and translated for Delano.

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