March 22, 2023

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The European Central Bank pushed forward with a half-point increase in interest rates on Thursday, sticking to its previously announced anti-inflation plan, but said recent turmoil in financial markets made the way forward less certain.

Over the past few days, since the collapse of three medium-sized banks in the US, investors have gripped concerns about other banks, including major Swiss lender Credit Suisse, and about the sector’s ability to withstand higher interest rates. The European Central Bank was the first major central bank to set monetary policy since volatility began late last week.

Christine Lagarde, the bank’s president, said at a news conference Thursday that policymakers are “monitoring the current market tensions closely.” She added that the bank “stands ready to respond as necessary to maintain price stability and financial stability in the euro area.”

Despite the added uncertainty, policymakers did not deflect the half-percentage-point rate hike they first said in early February was coming. The bank said it would raise the deposit rate to 3 percent on Thursday, the highest rate since October 2008.

“Inflation is expected to remain very high for a long time,” Lagarde said, adding that the move was necessary to ensure that inflation returned “in due course” to the bank’s 2 percent target. Bank staff expected inflation to average 5.3 percent this year and remain just above the 2 percent target in 2025.

What follows in the coming months is less clear. Lagarde said that if the bank’s economic outlook emerges after the current market uncertainty recedes, policymakers still have “a lot of ground to cover” on tightening monetary policy. But this is a big deal if.

That was a sharp change from the past few months, when the central bank has been lighting the way for investors, committing to its next rate move in advance.

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Lagarde said the data used to make the forecasts were finalized at the beginning of March, before the recent market turmoil, so policymakers faced higher levels of uncertainty in their decision-making.

“There was a degree of uncertainty that was there beforehand, but it’s certainly been exacerbated by the recent financial tensions that we’ve noticed in the last few days,” Ms. Lagarde said. “It is clear that it is difficult for a group of 26 members of the Board of Directors to reach a decision in the face of” the incoming economic and financial data, she added.

“We were certainly confident that this 50 basis point increase was a solid decision given the ground to cover,” she said, but she later noted that few policymakers wanted more time to see how the situation developed.

In Frankfurt, where European Central Bank officials met on Thursday. The bank said it “stands ready to respond as necessary to maintain price stability and financial stability in the euro area.”credit…Michael Probst / Associated Press

With financial markets turbulent this week, traders have cut their bets on how major central banks will raise interest rates this year amid the fallout from the collapse of the California-based Silicon Valley bank and concerns about Credit Suisse. Analysts are beginning to speculate that the US Federal Reserve will not be able to proceed as expected with higher interest rates as markets remain nervous about the health of many banks, particularly US regional banks, and their ability to afford higher rates.

The Federal Reserve and the Bank of England are set to meet next week to set interest rates.

The eurozone has little direct exposure to Silicon Valley bank, but banking concerns came a little closer to home on Wednesday when Credit Suisse’s share price plunged to a record low after the Swiss bank said it found “fundamental weaknesses” in its financial reporting controls. About pumping more money for regulatory reasons.

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Early Thursday, Credit Suisse said it would borrow up to 50 billion Swiss francs, or about $54 billion, from the Swiss central bank and buy back some of its debt. Hours later, shares in Credit Suisse jumped at the start of trading, ending the day up about 20 percent.

The European Central Bank stressed on Thursday that it has tools to protect financial stability in the region, but said the banking system is “resilient, with strong capital and liquidity positions.”

He also highlighted a new tool, the Transportation Protection Instrument, that was created in the summer and could be used to counter “undue and unregulated market dynamics” that threaten the central bank’s ability to implement monetary policy decisions.

The central bank is “fighting the problems of price stability and financial stability with two separate tools in order to avoid conflicting objectives,” wrote Jörg Kramer, chief economist at Commerzbank, in a note. He added that there are good reasons for this because “the deep problem of inflation has not changed so far.”

It expects the bank to raise interest rates by a quarter of a point at each of its next two meetings, bringing the deposit rate to 3.5 percent, lower than a previous forecast of 4 percent. Mr Krämer added that market turmoil could “weaken bank lending – and ultimately growth and inflation”.

Ms. Lagarde emphasized that future price decisions will be “data-driven,” which includes financial data. The Bank will be particularly vigilant to lend to households and businesses, if constraints emerge and the extent to which financial conditions tighten the economy.

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“It is not possible at the moment to say which path the future will take,” European Central Bank President Christine Lagarde told reporters after the bank’s meeting in Frankfurt on…Heiko Becker/Reuters

Last month, policymakers at the European Central Bank said they expected to raise interest rates by half a point at this week’s meeting because they are committed to stemming persistent inflationary pressures even as the inflation rate appears to be peaking. Consumer prices in the 20 countries that use the euro as their currency rose at an annualized rate of 8.5 percent in February, down slightly from January, and down from a peak of 10.6 percent in October.

Beyond the headline rate of inflation for the eurozone as a whole, the details were more of a concern to some policymakers. And some major economies, including France and Spain, have recorded high inflation rates. The core inflation rate, which excludes volatile energy and food prices and is used to measure the extent of inflation inherent in the economy, also rose last month.

Lower wholesale energy prices in Europe will help push inflation towards the central bank’s 2 percent target. But policymakers are focusing on so-called core inflation, which will show whether inflationary pressures are still building up and making it difficult to meet the inflation target on a sustainable basis. Measures such as wage inflation and service inflation are watched closely, and current underlying inflation trends do not confirm that inflation is on target.

On inflation, “we’re seeing some slight improvement in certain areas but not much, frankly,” Lagarde said.

While markets remain jittery and the extent of the impact on the banking sector remains unknown, there is a risk that central banks may appear off-target inflation targets, after spending months warning that high prices may be more sticky than expected.

But Ms. Lagarde tried to push back against suggestions that the European Central Bank would prematurely declare victory in the war against inflation. “We are not backing down from our commitment to fight inflation,” she said. “That should not be in doubt. The identification is sound.”