In an effort to combat rising consumer prices, the European Central Bank (ECB) has increased its benchmark interest rate by 25 basis points. This decision brings the rates to levels not seen since November 2008, with the benchmark rate set to move to 3.25% as of May 10. The ECB cited concerns about the persistently high inflation outlook, noting that although headline inflation had declined in recent months, underlying price pressures remained strong. The bank began raising rates in July 2022, moving its main rate from -0.5% to zero, but despite consistent rate increases, inflation has remained well above its target of 2%. According to estimates from the International Monetary Fund, inflation is unlikely to reach the ECB’s target until 2025. Recent data showed that the euro zone economy grew less than expected in Q1 2023, but unemployment figures improved slightly in March. An ECB survey also revealed that access to credit has tightened significantly, potentially indicating that higher interest rates are beginning to impact the real economy.
In its recent rate decision, the ECB acknowledged that past rate increases have been effectively transmitted to the euro area's monetary and financing conditions. However, it also acknowledged the uncertainty surrounding the lags and strength of transmission to the real economy and did not provide any further guidance on future rate decisions. Additionally, the ECB announced that it would likely cease reinvestments under its Asset Purchase Program in July. The program was initially launched in mid-2014 to address low inflation levels and was paused between January and October 2019, before continuing until July 2022 with reinvestments of matured assets. The decision to cease reinvestments was viewed as a hawkish compromise by the ECB, with some members of its Governing Council pushing for a larger rate hike. ECB President Christine Lagarde noted that there is a divergence across sectors of the economy, with the manufacturing sector facing worsening prospects while the services sector is growing. Lagarde emphasized that the decision to raise rates was necessary, and there will be no pause, as there is more ground to cover.
On Wednesday, the Federal Reserve announced a 25 basis point increase in rates, taking its funds target range to 5-5.25%, the highest level seen since August 2007. Additionally, the central bank hinted at the possibility of pausing rate hikes soon. These decisions have been made against the backdrop of persistent pressures on the banking sector, particularly in the United States. For example, earlier this week, JPMorgan announced its acquisition of First Republic, a smaller lender that has struggled to survive in the higher interest rate environment. The CEO of Unicredit, an Italian bank, also suggested on Wednesday that more bank rescues may be required in the US. Such stresses in the banking sector could bolster the arguments of dovish central bankers who are concerned about the implications of higher rates on the broader economy.
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