ECB Is Doubling Down on Rate Hikes Just as a Recession Bites

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(Bloomberg) — The European Central Bank’s warning that aggressive interest-rate hikes are far from over is raising the stakes for the euro region, just as a recession takes hold.

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(Bloomberg) — The European Central Bank’s warning that aggressive interest-rate hikes are far from over is raising the stakes for the euro region, just as a recession takes hold.

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Every increase in borrowing costs, including Thursday’s half-point move, advances the fight by Frankfurt officials against rampant inflation — but also risks a higher toll on the economy. The trade-off means the potential cost of an error is rising with each decision.

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With inflation in double digits and projected by officials to stay above their 2% goal for years to come, this week’s meeting both rounded off six months of drastic action and set the tone for further forceful monetary tightening.

The accompanying rate hike may have been slower than the prior 75 basis-point steps, but President Christine Lagarde insisted investors shouldn’t read anything into that. More half-point moves are in store, she said, even while acknowledging that a “shallow” economic slump is probably already here.

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“This is a very tough message, and the conclusion of course is that the two quarters of mild recession that’s projected by the ECB will have to become a full-fledged recession,” the central bank’s former chief economist, Peter Praet, told Bloomberg Television. “What we are discussing is the possibility of a monetary-policy mistake. That means that the ECB underestimates the weakness of the economy.”

What officials now predict for gross domestic product next year is a paltry 0.5% expansion, after a contraction in the current quarter and another in the following three months. The recovery that then takes hold is projected to stay below a pace of 2% thereafter.

Given the inflation backdrop, however, the ECB didn’t let the lackluster growth outlook distract from its determination to achieve price stability. The prior day, the US Federal Reserve was similarly hawkish, unveiling a half-point hike and the view that there’s more work to do. 

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The ECB’s argument focused on whether to raise by another outsized increment of 75 basis points. Opposition to a smaller move was only overcome after a compromise to signal future moves and to agree on a prompt start to balance-sheet reduction, according to people familiar with the matter. 

With the deposit rate now at 2%, observers see a path clear for several more increases.

“We’re talking about a level of interest rates that will probably end up around 3.5%,” said Thomas Gitzel, an economist at VP Bank in Vaduz, Liechtenstein. “Yes, more is to come, but we’ll be able to live with it. I don’t think the ECB is making a mistake — on the contrary, it’s acting adequately for the first time.”

Carsten Brzeski, global head of macro at ING, is more circumspect, saying that only time will tell if the ECB is on the wrong track.

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What’s notable, he wrote in a report, is that the euro-zone economy is probably the hardest-hit in the current crisis of spiraling energy costs and squeezed supply chains — and yet its central bank is most determined to make policy restrictive.  

Such a juxtaposed position may set the scene for greater disagreements between ECB officials next year, complicating Lagarde’s task in achieving consensus on the Governing Council.

For those worried about the harm to growth, one pressing risk is of the longer-term harm that the economy may ultimately face.

With Russia’s war in Ukraine and climate-change concerns making an energy transition more urgent, trillions of euros in investments will be needed in the coming years. That spending may be jeopardized if rates rise to levels governments, businesses and households can’t afford.

The consequence may then mean inflation in the 19-nation euro zone stays higher for longer because the infrastructure needed to effectively reduce price pressures isn’t built — eroding competitiveness and damping private demand.

Even without touting such a longer-term view, Praet — who was one of the ECB’s most dovish officials under the leadership of former President Mario Draghi — remains uneasy with Lagarde’s policy and rhetoric. 

“This is quite hawkish — in a very uncertain environment,” he said.

—With assistance from Guy Johnson and Alix Steel.

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