“So we have to do what we have to do, which is currently to hike,” stated European Central Bank president Christine Lagarde during the previous monetary policy meeting on 27 July 2023. Photo: European Central Bank

“So we have to do what we have to do, which is currently to hike,” stated European Central Bank president Christine Lagarde during the previous monetary policy meeting on 27 July 2023. Photo: European Central Bank

After a tumultuous six-week period following the last monetary policy meeting on 27 July--during which inflation remained unmoved at 5.3% for both July and August and the eurozone economy showed signs of weakening--the European Central Bank took what is likely its final step by raising the key banking rates by 25 basis points. This is the highest increase in terms of deposit facility rates in its 24-year history.

Amid concerns of persistent inflation, the European Central Bank (ECB) has taken decisive action. On 14 September, the governing council a 25 basis points increase in the three key interest rates--the main refinancing operations, the marginal lending facility and the deposit facility. These rates will be 4.50%, 4.75% and 4.00%, respectively, effective from 20 September 2023.

This move aligns with the council’s ongoing monitoring of economic and financial data, inflationary dynamics and the strength of monetary policy transmission.

The decision comes on the heels of the 2023 State of the Union address by European Commission president Ursula von der Leyen. The address three crucial economic challenges facing the European Union: labour and skills shortages, inflation and the need for simplified business processes. Her emphasis on ‘persistent high inflation’ likely reinforced the resolve of hawkish members within the ECB’s governing council, leading to their unanimous focus on inflation control.

ECB president Christine Lagarde defended the rate hike as a necessary step to accelerate the reduction of inflation, currently much higher than the 2% target. She acknowledged that while the decision could potentially strain the economy, it was crucial for reining in inflation.

Economic outlook and implications of the rate hike

Despite the commitment to combat inflation, the euro area economy faces challenges. According to the ECB’s September staff macroeconomic projections, average inflation is expected to be 5.6% in 2023, 3.2% in 2024, and 2.1% in 2025. The 2023 and 2024 projections have been revised upwards due to rising energy prices, whereas the 2025 projection has been revised downwards.

The rate hike has in the euro area, dampening demand and adding further drag to an economy now projected to expand by just 0.7% in 2023, 1.0% in 2024, and 1.5% in 2025. Amidst these economic uncertainties, robust employment and wage growth stand as the sole arguments supporting the ECB’s controversial decision.

Asset purchase programmes and future outlook

In terms of asset purchase programmes, the APP portfolio is set to decline at a measured pace, whereas the pandemic emergency purchase programme (PEPP) portfolio will continue to see the reinvestment of principal payments from maturing securities until at least the end of 2024, according to the monetary policy statement.

Lagarde reiterated that the ECB remains to steering inflation back to its 2% target. The bank will continue to evaluate data and adjust its policies accordingly, maintaining its stance that monetary policy is the principal instrument for inflation control.

The ECB’s continued hawkish policy stance aimed at tackling inflation, even as the broader euro area economy shows signs of slowing, will be under close scrutiny in the coming months.