The European Central Bank entered into a new era on Thursday, as policymakers clearly stated their plan to raise interest rates next month for the first time in more than a decade.
To prepare for that move, the bank confirmed that it would stop growing its bond-buying program at the beginning of July. After eight years, the end of negative interest rates and massive bond buying, especially of government debt, is in sight.
Across the eurozone, inflation has outpaced economists’ expectations: The annual rate of price increases climbed to 8.1 percent in May, the highest since the creation of the euro currency in 1999. Policymakers have been spurred into faster action against inflationary forces that are being stoked by the war in Ukraine.
“High inflation is a major challenge for all of us,” the bank said in a statement, as it warned that inflationary pressures had “broadened and intensified,” reaching more goods and services. Most of the goods and services used to measure inflation are rising by more than 2 percent, the central bank’s 2 percent target. Inflation, excluding food and energy prices, which tend to be more volatile, is also expected to exceed the bank’s 2 percent inflation target through 2024.
The statement was explicit about raising rates, saying that the bank planned to raise its key rates by a quarter-point at its July meeting, adding that it expected to raise rates again in September. After that, there will be a “gradual but sustained path” of future increases, the bank said.
If the inflation outlook persists or deteriorates then the bank would consider a larger jump in rates in September than in July. Some policymakers had already been advocating for a half-percentage point increase.
Stocks in Europe fell, with the Stoxx 600 index down more than 1 percent in trading after the central bank announcement. Bonds also sold off, which raised yields, a measure of borrowing costs. The euro fell slightly against the dollar.
The central bank also updated its forecasts for the economy on Thursday, painting a grim picture of rising inflation and a deteriorating growth outlook as the war in Ukraine disrupts trade and pushes energy and commodity prices higher. This year, inflation will average 6.8 percent, up from 5.1 percent projected in March. The bank said the economy will grow 2.1 percent this year, slower than the previous forecast of 3.7 percent.
“Inflation will remain undesirably elevated for some time,” the central bank said on Thursday.
The need to tackle inflation is outweighing concerns about a slowing economy.
The European Central Bank has been slower to tighten its monetary policy compared to other major central banks in the United States and Britain because it expected the sharp rise in inflation to be temporary and reverse relatively quickly as energy prices settled. In Europe, there were also fewer signs of second-round inflationary effects, such as workers demanding large wage increases in response to rising prices.
For much of the past decade, policymakers have been battling against inflation that was too low. But as consumer prices began climbing and spreading to more goods and services in late 2021, the bank has ramped up its process of so-called policy normalization, including the possibility of raising its negative interest rate.
On Thursday, the bank said it forecast the annual inflation rate to be 2.1 percent for 2024, above the bank’s 2 percent target, cementing the conditions for monetary tightening.
At the moment, the central bank’s deposit rate, which is what banks receive for depositing money with the central bank overnight, is at minus 0.5 percent, in effect a penalty meant to encourage banks to lend the money rather than keep it at the central bank. The rate was first cut below zero in mid-2014 as the inflation rate fell toward zero.
As a precursor to raising rates, the bank’s bond-buying program, a way of keeping borrowing costs down and injecting money into the system, is set to end in early July, policymakers said. (A special pandemic-era bond-buying program ended in March after 1.7 trillion euros in purchases.) This month, the bank is set to buy €20 billion in mostly government bonds. The program started in 2015, and its purchases have grown and shrunk as policymakers tried to heat up and cool down the economy as necessary. As of May, holdings in the program amounted to more than €3 trillion in bonds.
Officials will be carefully watching the borrowing costs of countries with high debt burdens, such as Italy, as interest rates rise. The aim is to ensure that the interest rates they pay on their bonds don’t diverge too much from other countries in the bloc, such as Germany, in order to keep borrowing costs uniform among the countries using the common currency.
The spread between Italy’s 10-year government bond yield and Germany’s has grown to more than 2 percentage points, the widest since early 2020, when the onset of the coronavirus pandemic roiled financial markets. A particularly large jump in yields on Italian government debt on Thursday outpaced the rise on the equivalent for German bonds, further widening that spread.
The reinvestment of proceeds from maturing bonds could be used to avoid this so-called fragmentation. The central bank has already stressed that there is flexibility in its pandemic-era purchase program.
