FRANKFURT — The European Central Bank is about to show it means business in the fight against inflation even as recession risks loom in the eurozone.
The key question ahead of Thursday’s Governing Council meeting is whether policymakers will raise interest rates by 50 basis points or 75 basis points, with more and more signs pointing to the largest rate increase in the ECB’s history.
Europeans have now suffered more than a year of above-target inflation, which just keeps climbing and climbing. Many households, especially the poorer ones, are struggling to make ends meet and are dreading the cold season, when heating bills will skyrocket.
The ECB was slow to react to inflation, noting that in Europe inflation is largely imported and should ease without central bank intervention as global commodity prices, particularly for energy, come down. Yet with no such decline in sight, price increases seeping through the economy and inflation expectations on the on the rise, policymakers have signaled a shift in gears.
Investors are largely betting a on a jumbo 75-basis point move after headline inflation hit a record 9.1 percent in August. On Tuesday, markets priced in an 80-percent chance of a 75-basis point hike.
Economists are more cautious and divided: “We think it is a very close call, with good arguments on each side,” said Morgan Stanley economist Jens Eisenschmidt. He expects that those advocating for a larger hike will prevail.
The key argument for aggressive action is that it would send a clear signal of the ECB’s unwavering commitment to delivering price stability, after it underestimated price pressures for months. Sending such a signal would limit the risk of inflation expectations unanchoring and forcing even more aggressive tightening down the road.
A more conservative 50-basis point approach is seen as guarding the ECB against the risks of having to reverse its policy – not unlike in 2008 and 2011 – amid mounting risks of a recession. As ECB chief economist Philip Lane pointed out last week, a “multi-step adjustment path … makes it easier to undertake mid-course corrections if circumstances change.”
The outcome of deliberations on the Governing Council will be closely linked to updated projections for growth and inflation also due to be released on Thursday.
While the inflation outlook is expected to be revised up to see prices overshoot target across the forecast horizon, the growth outlook is set to be trimmed. The ECB in June still saw GDP growth topping 2 percent in 2023 and 2024, but next year’s number will see a hefty cut even if the central bank may shy away from penciling in the recession seen by many private forecasters.
Some economists argue that no matter what these new growth projections show, inflation has been too high for too long for the ECB to be able to afford any more caution.
“Forceful action is … inevitable, with no room for prudence,” said SG Global economist Anatoli Annenkov. In fact, he argues that given the threat to the ECB’s credibility, policymakers should mull even more aggressive action and stop reinvesting the proceeds from bonds it bought at a time when it still sought to push up inflation.
The trouble for the ECB is that if acts too aggressively, this could push the borrowing cost of highly indebted countries, such as Italy, significantly higher, adding to economic challenges and potentially stirring concerns over a looming debt crisis.
This may argue for a typical ECB compromise between doves and hawks on the Governing Council. The hawks get a mammoth move to demonstrate the ECB’s resolve in its fight against inflation and, in return, agree to leave a debate about reducing the central bank’s balance sheet until later.
Another reason to tip the balance toward a 75-basis point move is market expectations for it. Disappointing markets with a more timid move risks pushing down the euro exchange rate even further, thus pushing up imported inflation even more. With the euro already below parity to the U.S. dollar for the first time in 20 years, any further weakness might turn people more skeptical toward their joint currency.