In a bold attempt to keep inflation in check, the European Central Bank announced Thursday that it would raise its benchmark interest rate by half a percentage point.
It is the first time since 2011 that the ECB has raised interest rates and brought the main European interest rate back to zero. Rates in the region have been negative since 2014.The move, which takes effect on July 27, comes as Europe battles record inflation fueled by rising energy prices. Annual inflation in the European Union rose to 9.6% in June. It reached 8.6% for the 19 countries that use the euro.
The central bank had previously indicated it would raise interest rates by a lower margin, but decided it needed to be more aggressive based on an "updated inflation risk assessment".
"Inflation remains undesirably high and should remain above our target for some time," ECB President Christine Lagarde said at a news conference.
The central bank has refused to commit to a definitive trajectory for future rate hikes in an attempt to keep its options open.
"From now on, we will make our monetary policy decisions based on the data," said Lagarde. "We will work month after month and step by step. What happens in September depends on the data we have for September ".
The ECB also unveiled a new bond purchase tool designed to control borrowing costs in highly indebted eurozone countries like Italy and Greece. The central bank wants to maintain cohesion within the region that uses the single currency.
The so-called transmission protection instrument "could be activated to counter unjustified and disordered market dynamics that pose a serious threat to the transmission of monetary policy in the euro area," the central bank said.
The European Central Bank is ready to use the tool if necessary, provided that countries meet certain criteria for fiscal and economic health, Lagarde stressed.
"I can assure you that we prefer not to use TPI," she said. "But if we have to use it, we won't hesitate."
A network of risks
Investors reacted lukewarmly to the announcement. The euro, which recently reached parity with the US dollar for the first time in two decades, rose to around $ 1.02 after the announcement. European equities struggled to find direction, leaving the Stoxx 600 index flat.
The weakness of the currency exacerbates the inflation problem, as it forces European companies to pay more for imports, including energy.
The ECB faces an uphill climb as it intensifies its efforts to stem the rapid rise in prices. As the summer tourist season, pandemic-era austerity and a solid labor market continue to support the European economy, growth is slowing.
The central bank has not yet entered a recession. In June, it said it expects production growth of 2.8% this year and 2.1% in 2023.
"In the base case, there is no recession, neither this year nor close to the year," Lagarde said Thursday, while acknowledging that the horizon is "cloudy".
The risks of recession could limit the ECB's ability to continue raising interest rates, helping to fight inflation but also slowing the economy.
The ECB is already far behind its competitors. After slashing interest rates to zero at the start of the pandemic, the Fed has been on a rate hike spree since March, raising interest rates by leaps and bounds in recent months to combat the galloping inflation. Only the Bank of Japan – which maintained its super accommodative policy on Thursday – did not back down.
It also struggles with high levels of uncertainty regarding energy supplies, which makes it difficult to predict future inflation.
Russia's Gazprom resumed gas supplies along its vital Nord Stream 1 pipeline on Thursday, allaying fears it could restart after a scheduled maintenance period. But it is not operating at full capacity, and there are fears that Russia could cut the gas again at some point in retaliation for Western sanctions. Moreover, Europe's third-largest economy is in the midst of a political crisis that is shaking the country's financial markets. Italian Prime Minister Mario Draghi, a darling of investors, tendered his resignation to the president on Thursday after losing the support of several key parties in his government coalition. This could lead to early elections.