Defying the European economic slowdown, the European Central Bank (ECB) has raised its interest rates by 25 basis points, reaching a level not seen since 2001. This move, coupled with the bank's dovish tone in its interest rate statement, has led to a significant drop in the value of the euro.
Interest Rate Hike and Market Reactions
On July 27, the ECB announced its latest interest rate decision, which increased its three primary interest rates by 25 basis points, in line with market expectations.
The deposit facility rate hit 3.75%, marking the highest level in 22 years. The refinancing rate reached 4.25%, and the marginal lending rate came to 4.50%. These three key ECB rates have risen a total of 425 basis points in less than a year.
The ECB noted in its rate statement that they anticipate inflation to remain elevated for an extended period. The persistently high underlying inflation and the continued pass-through of past rate hikes in the financial environment have once again tightened financing conditions, which are crucial factors for inflation to return to the target level.
The bank further clarified that the key interest rates would stay at a sufficiently restrictive level for as long as necessary to achieve a medium-term inflation target of 2%. The Governing Council underscored that it would continue to determine the "restrictiveness level and duration" of the interest rates based on data.
The most significant change in the ECB's interest rate statement was its shift from last month's comment on rate peaks to ensure that rates reach a "sufficiently restrictive" level. This change, seen as dovish by market participants, contributed to a drop in the value of the euro against the U.S. dollar.
Asset Purchase and Emergency Purchase Programs
Regarding the Asset Purchase Program (APP) and the Pandemic Emergency Purchase Program (PEPP), the ECB stated that the APP portfolio is decreasing at a predictable and orderly pace and will no longer reinvest in maturing securities' principal payments.
As for the PEPP, the Governing Council plans to reinvest the principal payments from securities purchased under this program at least until the end of 2024. The future gradual reduction of the PEPP portfolio will be managed to avoid disrupting an appropriate monetary policy stance.
Meanwhile, the ECB has reduced the minimum reserve requirement for banks to zero from the previous 3.25%, aiming to increase the effectiveness of its monetary policy. Arne Petimezas, a senior analyst at AFS Group, noted this move is purely profit-driven and could save the ECB 6 billion euros per year.
Reactions and Predictions
Mark Wall, Deutsche Bank's chief European economist, in his response report mentioned, "The zero minimum reserve rate was unexpected. It reflects a further tightening of the ECB's stance."
The ECB stated it is ready to adjust its policy tools at any time to ensure inflation returns to its 2% target and maintains the smooth operation of monetary policy transmission. It also highlighted that transmission protection tools could be used to counter irrational and disorderly market dynamics that pose severe threats to the monetary policy transmission in all eurozone countries, thus enabling the Governing Council to fulfill its price stability responsibilities more effectively.
However, the market interpreted the ECB's interest rate statement as dovish, leading to a rise in German bond yields and a drop in the euro to the U.S. dollar, reaching a two-week low at 1.1020.
Differing Opinions Within the ECB
Christine Lagarde, President of the ECB, reiterated during a press conference that the change in language in the statement was neither random nor insignificant. She stated that she would approach decisions in September and beyond with an open mind, suggesting that a rate hike could be possible or paused, but a rate cut would not happen.
While inflation is gradually falling in the eurozone as a whole, core inflation remains at a historic high of 5.4%. However, the eurozone's macroeconomic data continues to decline, and recession signals in various countries are flashing. This "contradiction" between high core inflation and slowing economies is causing increasing divisions within the ECB.
Several hawkish and dovish officials within the ECB have expressed differing views on the bank's current tightening stance and future interest rate path, suggesting that the path to tighter monetary policy in Europe remains fraught with uncertainty.
