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European Central Bank raises rates to tackle inflation, despite slowdown risks

The energy crisis is pushing prices up all over Europe while slowing economic growth

Sunflowers bloom in front of the European Central Bank headquarters in Frankfurt, Germany. The bank raised its main deposit rate by three-quarters of a percentage point on Thursday. (Ronald Wittek/EPA-EFE/Shutterstock)

The European Central Bank on Thursday announced its largest-ever increase in interest rates, as officials confront a nightmare scenario of soaring inflation coupled with an economy that appears to be stalling.

Meeting in Frankfurt, Germany, the bank’s governing council raised its main deposit rate by three-quarters of a percentage point, joining the Federal Reserve and other major central banks in a full-throated assault on rising prices, economists said.

ECB President Christine Lagarde said the supersized rate increase was needed because August’s 9.1 percent inflation rate was “far away” from the bank’s 2 percent goal.

Europe faces a multiyear fight to bring rising prices under control, she said, even as the bank’s forecast calls for output in the euro area to “stagnate” for the next six months.

“Nobody should expect inflation is going to return to 2 percent in the next three months,” she said. “We have a goal. We have a mission. We have incredibly high inflation numbers. The ECB is serious about returning inflation back to 2 percent.”

Historically high inflation has bedeviled almost every advanced economy over the past year. As consumers and businesses resumed normal activities and pandemic restrictions eased, strong demand for goods and services collided with persistent supply shortages, sending prices higher.

Major central banks have responded by lifting interest rates from ultralow levels, aiming to slow economic activity by raising the cost of borrowing. The ECB joined the Federal Reserve in the United States and the Bank of Canada, which acted on Wednesday, in executing jumbo three-quarter point hikes.

Rate hikes are little help for Estonia’s 22% inflation, Europe’s worst

The Bank of England last month raised its benchmark lending rate by half a point, its largest increase in 27 years.

And additional increases are coming. Investors say there is an 86 percent likelihood that the Fed will raise rates later this month by an additional three-quarters of a point, according to CME Group’s Fedwatch. Lagarde said Thursday that the ECB plans “several” more increases. And the Bank of England is expected to raise rates again next week as it battles annual inflation that tops 10 percent.

The war against inflation comes against a backdrop of sagging global growth. The world’s three largest economies all are slowing: The United States is increasingly feeling the effects of the Fed’s higher interest rates; China is saddled with a debt-ridden property sector, flagging exports and rigid coronavirus lockdowns; and Europe is reeling from skyrocketing energy costs.

“It’s going to be a cold winter for the global economy,” said Neil Shearing, chief economist for Capital Economics in London.

Each central bank is grappling with a slightly different inflation challenge.

The Fed is trying to cool off an overheated labor market, where there are two job openings for every unemployed person. In Europe, by contrast, there are three job seekers for every vacant position and the chief problem is a lack of adequate supplies of natural gas, Lagarde said.

“Inflation in the U.S. is largely driven by demand. In the euro area, it is largely driven by supply,” she added.

Yet as higher energy bills infect other parts of the economy, Europe’s inflation woes are spreading. Core inflation, excluding volatile energy and food prices, rose 4.3 percent in August compared with 1.6 percent in the same month in 2021, according to the ECB.

“The energy shock is not staying in energy,” said David Page, head of macroeconomic research at AXA Investment Managers in London.

Europe mulls drastic moves to control prices as Russia energy war heats up

In a statement, policymakers said they had acted “because inflation remains far too high and is likely to stay above target for an extended period.” They also warned that they expect to raise rates further in the coming months.

ECB staff also have revised up their forecast of future inflation and marked down the euro area’s growth prospects. The bank now expects inflation this year to average 8.1 percent before declining slowly to 5.5 percent next year and 2.3 percent in 2024, meaning the pace of annual price increases will exceed the bank’s target for at least three full years.

“These inflation levels imply a dramatic decline in real wages (5% or so) in [the euro area] in 2022,” economist Jacob Kirkegaard of the Peterson Institute for International Economics said in an email. “This is unprecedented.”

The ECB said the European economy will skirt an outright recession this year, expanding by 3.1 percent. But the expansion will come close to stalling next year, with growth dipping below 1 percent before staging a mild comeback in 2024 to a 1.9 percent gain.

While higher interest rates are expected to slow the economy and thus ease pressure on prices, they also could make an increasingly gloomy economic outlook even darker.

“They are in an impossible situation,” said Eric Winograd, senior economist with AllianceBernstein in New York. “They are confronting a shock to which there is no good policy response.”

Lagarde acknowledged the challenge, noting that additional rate increases will do nothing to cure the continent’s energy ills.

European households and companies are facing a severe energy crunch this winter following Russia’s decision to halt natural gas deliveries to Europe via the Nord Stream 1 pipeline. Moscow blames technical problems with its main pipeline related to Western sanctions over the war in Ukraine. But European officials see the move as punitive, designed to weaken opposition to the Russian invasion.

The euro-area economy grew in the second quarter by 4.1 percent compared with one year earlier. But as natural gas prices soar, some of Europe’s industrial giants are eyeing possible work slowdowns and output reductions to conserve fuel.

The ECB raised its main deposit rate by a half-point in July, its first increase in 11 years, and it signaled that additional such moves lay ahead. But European policymakers have moved more slowly than the Federal Reserve, and higher U.S. interest rates have contributed to the euro’s 16 percent decline against the dollar.

Thursday’s decision took the deposit rate to 0.75 percent and increased two other rates that govern European banks’ short-term borrowings from the central bank.

Inflation is a Europe-wide problem, but it is not uniform. In France, prices are rising at an annual rate of about 6 percent, while in tiny Estonia, inflation tops 25 percent.

Even as traders were forecasting a significant rate increase this week, the euro drifted lower against the dollar.

“Markets are looking through ECB hikes and focused on the looming deep recession that will engulf the Euro zone. ECB hikes will make that recession worse, not better,” Robin Brooks, chief economist for the Institute of International Finance, wrote on Twitter.

The weaker euro is only making inflation worse. Oil and other energy products that trade globally are priced in dollars. So the falling euro effectively makes them more expensive for European customers.

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