The European Central Bank Hikes Rates by 0.5%, More than Previously Communicated

Rate Lift-off after 11 Years

The European Central Bank raised all three key interest rates by 50 basis points today ^[1], which was more aggressive than its previously communicated path for a modest 0.25% adjustment ^[2]. Earlier this week however, a Reuters report had suggested that officials would consider a 0.5% adjustment. ^[3]

After the first hike in more than a decade and of the biggest size since 2000, the Deposit Facility Rate has now exited negative territory and stands at 0.00%.

The central bank pointed to more rate increases ahead, saying that "further normalisation of interest rates will be appropriate" in the upcoming meetings. The Governing Council also noted that today's bold adjustment allows it to implement a "meeting-by-meeting approach" regarding the next rate decisions.

What Happens in September?

Given this outsized move, focus now shifts to what the bank will do at the next meeting in September, and if the previous hint for a larger than 25bps hike is still valid.

At today's press conference, Ms Lagarde said that the previous forward guidance that existed for September is "no longer applicable". She added that today's 50 bps hike, does not change the "ultimate point of arrival" and that "we are accelerating the exit". ^[4]

That was probably a rather vague reference, which we are not sure what it means, but it did appear to pour cold water to expectations to another big hike at the next meeting, since EUR/USD reacted negatively to this reference.

Transmission Protection Instrument

The central bank also approved the Transmission Protection Instrument (TPI), designed to ensure that the monetary policy stance is transmitted "smoothly across all euro area countries".

This is an anti-fragmentation tool, that can be activated if necessary, intended to support the more indebted countries of Eurozone, which are more vulnerable to the negative effects of monetary tightening.

Ms Lagarde stressed that this is an addition and "not the only tool" that the ECB has in its arsenal in this respect, mentioning the flexible reinvestment of PEPP and the Outright Monetary Transactions (OMT,) which allows the bank to purchase debt form specific countries.

The new political turmoil in Italy, after today's resignation of Prime Minster Draghi has put pressure on Italian bonds, highlighting the potential importance of such instruments.

Surging Inflation vs Economic Slowdown

Today's historic decision comes in order to fight surging inflation, which hit new record high in June, as this week's data showed that the Eurozone's headline Consumer Price Index jumped 8.6% year-over-year.

Officials judged that the updated assessment of inflation risks warranted the more aggressive rate increase, while Ms Lagarde called inflation "undesirably high" during the subsequent press conference and expects it to remain so for some time.

The President also commented on the recent fall of the common currency, acknowledging it as one of the sources of higher inflationary pressures.

However, Eurozone has many challenges to face which stem mostly form fallout of the war in Ukraine and which could spark a recession, thus limiting the ECB's ability and/or willingness to pursue further monetary tightening.

A key factor is the supply of gas from Russia, to which the continent and most importantly Germany is highly dependent, both the needs of consumer but also for Industrial production. Today, Nord Stream 1 resumed the supply of gas after the 10-day maintenance shutdown^[5], but fears that Russia will cut off supply as a retaliation for Western sanctions against it, remain high.

The ECB President acknowledged economic activity is slowing and that the war in Ukraine is an "ongoing drag on growth" and that a prolongation is a source of downside risk.

EUR/USD Reaction

Today's bold rate hike did not come as a surprise, after the Reuters reports, but the common currency strengthened after the announcement and as ms Lagarde's press conference got underway.

After her aforementioned reference however, on what today's move means for September, caused EUR/USD to give up the initial gains.