Former Council of Economic Advisers chair Kevin Hassett reacts to the stock market rally on ‘Kudlow.’
FRANKFURT — The European Central Bank raised interest rates again on Thursday and signaled it was keen to start shrinking its bloated balance sheet, taking another big step in tightening policy to fight off a historic surge in inflation.
Worried that rapid price growth is becoming entrenched, the ECB is raising borrowing costs at the fastest pace on record, with further hikes almost certain as unwinding a decade’s worth of stimulus will take it well into next year and beyond.
In a series of complex moves, the central bank for the 19 countries that use the euro raised its deposit rate by 75 basis points to 1.5%, as expected, taking the total increase to 2 percentage points over three meetings. Until July, ECB rates had been in negative territory for eight years.
The ECB also cut a key subsidy to banks but made no hint about plans to start winding down its bond holdings after hoovering up trillions of euros of debt issued by euro zone governments since 2015.
“The Governing Council took today’s decision, and expects to raise interest rates further, to ensure the timely return of inflation to its 2% medium-term inflation target,” the ECB said in a statement.
Markets expect the deposit rate to hit 2% in December, then peak at around 3% some time in 2023, although the excessively volatile outlook makes this timeline prone to changes.
While inflation is high and broadening, the overall picture may be more balanced than in the past as spot energy prices are falling, a looming recession will dampen price pressures, and there are no signs of a wage-price spiral.
BALANCE SHEET
The ECB also took the first step on Thursday toward shrinking its 8.8 trillion euro balance sheet, a move that is likely to raise borrowing costs further and may act as a sort of disguised rate hike.
In a step that may be fought by commercial banks, the ECB curbed the subsidy it provides to such lenders through 2.1 trillion euros worth of ultra-cheap three-year loans called Targeted Longer-Term Refinancing Operations, or TLTROs.
“In view of the unexpected and extraordinary rise in inflation, it needs to be recalibrated to ensure that it is consistent with the broader monetary policy normalization process and to reinforce the transmission of policy rate increases to bank lending conditions,” it said.
The ECB said that the interest rate on TLTRO operations will be indexed to the average applicable key ECB interest rates in the future. The aim of the change is to encourage early repayment of the loans.
The ECB, however, did not provide further pricing details and said these would be made available at 1345 GMT.
In another change, the ECB also said that minimum reserves would be remunerated at the deposit rate, rather than the main rate, which is 50 basis point higher.
Having borrowed at zero or even negative rates at a time when the ECB’s main worry was persistently low inflation, banks can now simply park TLTRO cash with the ECB and enjoy a risk-free return that rises with each deposit rate hike.
This is politically contentious in itself, but an abundance of liquidity is also keeping money market rates depressed and preventing the ECB’s rate hikes from being fully passed through via the banks to businesses and households.
The biggest chunk of TLTRO loans, worth around 1.5 trillion euros, expire next June. Thursday’s changes may encourage banks to repay them early – as soon as December – shrinking the ECB’s balance sheet in the process.
The bank confirmed its guidance on reinvestments of bonds maturing in its bond buying schemes, confounding some expectations for a small change that would hint at a wind down of the Asset Purchase Programme next year.
