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Taken by inflation, now the ECB’s hesitation is taking its revenge

An the capital market, eleven years is not long. Yet it was a different world economically when the European Central Bank (ECB) last raised the key interest rate in 2011. Inflation was two percent, federal bonds yielded more than three percent.

Much was also different politically. In 2012, for example, the euro zone threatened collapse due to the debts of the southern countries. In 2014, Russia annexed Crimea. In 2016, the British voted for Brexit. In the same year, the Americans appointed Donald Trump as their president.

Now, for the first time since 2011, the ECB is about to make money significantly more expensive. At her press conference, Central Bank President Christine Lagarde left no doubt that the institution will raise interest rates in July.

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“On the one hand, the decision is a turning point, on the other the ECB has missed the opportunity to send a sign of determination,” says Dirk Chlench, economist at LBBW.

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According to the statute, the main task of the ECB is to keep the value of money stable in the euro area. With an inflation rate above 8 per cent, as is currently being experienced in the monetary union, this can no longer be talked about.

The ECB expects to raise interest rates by 0.25 percentage points

And the external value of the European currency has recently suffered significantly. By mid-May, the euro had fallen below $ 1.04. This was the lowest level in nearly two decades.

The plan is to raise the key refinancing rate, as the key rate is called, to 0.25 percentage points in July. After the summer break in September, the next rate hike is expected.

If inflation does not fall significantly by then – which is likely – the September rate hike could go as high as 50 basis points. According to forecasts, the rate could be one percent by the end of 2022. In Frankfurt am Main there is talk of normalization.

The era of ultra-cheap money is over

While the ECB proceeds cautiously, some say hesitant, other central banks around the world have already tightened monetary policy. In the US, the Fed has now raised interest rates to 1%, as has the Bank of England. Canada has 1.50%, South Korea even 1.75%.

Many national economies are likely to make central bank money more expensive this year at a similar pace to Europeans, so that the interest rate differential should remain roughly the same. So the euro zone will not become a high interest zone for a long time to come. But the time for ultra-cheap money is over.

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“The ECB has officially ended the long era of unconventional monetary policy,” says Carsten Brzeski, chief economist for the euro zone at ING. This includes not only the prime rate. In addition to the announced rate hike, the bond purchase program that artificially lowered interest rates on long-dated government bonds and other fixed-income securities will also be halted. It expires on 1 July 2022.

Negative deposit rates for banks will also be reduced. But it remains to be seen whether the central bank is really willing to push inflation quickly to two percent – where its official target lies. Lagarde talked about achieving the “medium term” goal – a flexible deadline. “It is not a step, it is a journey”, is how the supreme guardian of the currency described the fight against inflation.

The ECB can do little to change high inflation

According to its own statements, the ECB can do little to change high inflation in the short term. In fact, monetary watchdogs are now even anticipating inflation of 6.8 percent for the full year, which is significantly higher than the previous forecast.

The sustained rise in prices and related fluctuations are dampening the mood of businesses and consumers. The cautious approach of currency watchdogs also means that savers still need to be patient. It will take months for interest to be paid back to savings accounts and overnight funds.

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However, the change in central bankers’ policy has already had an effect: capital market interest rates have started to move. “With the turnaround in interest rates now effectively set, government bond yields in euro countries have risen,” notes Ulrich Stephan, Deutsche Bank’s chief investment strategist.

Ten-year Bunds, which many see as a benchmark, fell 1.4% this week, the highest since 2014. The heavily indebted southern eurozone states have to pay significantly higher interest. Ten-year debt securities issued by the Italian state yielded 3.7 percent at one point.

New tensions in the euro area

If these interest rate differentials widen – traders speak of risk premiums or ‘spreads’ – this could lead to new tensions in the euro zone. For a country like Italy, whose liabilities represent 160 percent of economic output, rising financing costs can quickly become a problem.

The surge in spreads has threatened to blow up the pan-European capital market. In 2011/2012 this was the reason why the ECB entered the low-cost money policy.

Lagarde tried to allay concerns during the press conference: “If necessary, we will use existing custom tools or new tools.” The central bank will counter the fragmentation of the European capital market. The French left open which instruments exactly are.

It can be assumed that the management of rising spreads will shape the coming years. This raises the question of how long the ECB can support the normalization of interest rates.

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