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5 things to watch ahead of the ECB’s decision day

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FRANKFURT — The European Central Bank is bracing for a historic meeting on Thursday, when it’s due to take decisions that could make or break its credibility as an inflation fighter and show whether it can safeguard the cohesion of the currency union.

The central bank has signaled for weeks it’ll raise interest rates for the first time in over a decade to rein in inflation, which is running at more than four times its target. It’ll take this step against the backdrop of a war raging on Europe’s doorstep and political turmoil in Italy that’s threatening a new sovereign debt crisis.

POLITICO has broken down what to watch out for this Thursday.

Interest rates

The ECB said in June it plans to raise rates by 25 basis points (0.25 percent) at the July meeting, followed by a second, possibly larger, move in September unless prices start to cool. Inflation has stayed red-hot since then, prompting calls from some hawkish members to go as far as a 50-basis-point move on Thursday.  A 75 basis-point move in September should also be on the table, governing council member Robert Holzmann has suggested.

Most analysts, however, expect the ECB to stick to its guidance and deliver a 25 basis-point move. Such a hike would look half-hearted compared to some other central banks, which have already tightened more substantially. As ING strategist Francesco Pesole noted recently: “75 basis points is the new normal.”

The ECB, in effect, remains trapped between two risks: Not acting resolutely enough to counter inflation, which in turn could damage its credibility and force a more severe and painful adjustment later, or acting too aggressively and throwing the region into recession — possibly requiring a policy U-turn later. In that case, it would be the third time that the ECB hiked prematurely, after what are now seen as clear policy mistakes in 2008 and 2011.

Economic outlook

The risks of a downturn are real, economists warn. In June, the ECB still projected solid growth of 2.8 percent for this year and 2.1 percent in both 2023 and 2024. Since then, economists see the chance of recession rising, with some urging the ECB to hold off on tightening altogether. Investors have also scaled back future rate-hike expectations significantly.

Because the ECB is unlikely to offer clear guidance on the size and scope of rate hikes ahead, investors will try to read the tea leaves from Christine Lagarde’s assessment on the economic outlook, which will follow the rate announcement. But the current geopolitical environment makes this exercise challenging, analysts say.

“One problem is that, for example, a [Russian] gas shutdown would not only hit growth, but would also boost inflation,” said JP Morgan economist Greg Fuzesi. “Therefore the ECB may not immediately become more growth sensitive.”

Euro fall

Investors will try to read the tea leaves from Christine Lagarde’s assessment on the economic outlook | Stephanie Lecocq/EPA-EFE

Also of keen interest will be Lagarde’s comments on the euro, which has fallen to parity against the dollar for the first time in two decades. The two factors at play are the souring growth outlook, which may limit the ECB’s scope for rate hikes, and stronger demand for the dollar as a safe-haven currency since the start of the year.

A weaker euro adds to the ECB’s concerns because it pushes up inflation, especially via imported energy, which is generally priced in dollars. In response, Lagarde may try to talk up the euro’s strength, warning that the central bank will monitor exchange rates and their impact on inflation. The euro’s drop against other currencies has been less severe.

That all said, the central bank doesn’t have many good options, notes ING economist Chris Turner.

“Faced with the looming risk of recession — and the euro being a pro-cyclical currency — the ECB’s hands may be tied in its ability to threaten more aggressive rate hikes in defense of the euro,” he said.

Debt crisis

Then there is the question of whether the ECB can convince markets it’s able to stave off another sovereign debt crisis that would undercut the euro’s very viability. As part of this effort, the central bank has promised to design a new “tool” that it is widely expected to unveil later this week.

The tool will aim to limit government bond spreads — the premium that eurozone governments have to pay on top of ultra-safe German bonds — so long as they aren’t justified by economic fundamentals. The broader goal is to ensure that monetary policy is transmitted effectively across the region and keep borrowing costs for highly indebted countries from getting out of control.

For their part, most analysts expect the ECB to set fairly loose conditions for buying government bonds from member states. They also don’t expect the central bank to set ex-ante limits on those purchases — as a way to ensure maximum impact and avoid getting tested by markets.  

The catch, however, is that EU treaties prohibit the ECB from financing government debt. A tool that can keep spreads in check — with the central bank targeting bond buys from the countries most in debt — would require the Governing Council to pull off a fine balancing act on the legal side.

As Commerzbank economist Michael Schubert put it, “the more effective [the program], the more illegal” it will be.

Italian drama

The latest political instability in Italy — which could see Prime Minister Mario Draghi announcing he’ll step down just before the Governing Council meets in Frankfurt — has made that tightrope act even more dizzying.

The turmoil makes it all the more important that the ECB’s new tool is a powerful one. But it also highlights the difficulty in figuring out how much spreads are driven by irrational speculation, and how much by fundamentals.

These developments “could complicate the decision of unveiling such an instrument,” said Barclays economist Silvia Ardagna. “However, this will be even more important to prevent contagion and spillovers from Italy to other sovereign markets while the ECB increases policy rates.”

Ardagna added she doesn’t expect Italy to benefit from the tool if political uncertainty increases. In that case, the ECB might then consider market reaction justified.

Meanwhile, Italian spreads have risen above 200 basis points over German bunds, a level that Italian central bank chief Ingazio Visco has described as unwarranted.

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