Last 27th October, the Governing Council of the European Central Bank (ECB) met to deliberate on new important measures to restore price stability over the medium term and fight inflation in the euro area. On the same day, the President of the ECB Christine Lagarde announced three principal monetary policy decisions on the occasion of the ECB Press Conference.
The first measure is raising the three ECB key interest rates by 75 basis points, which marks the third increase in a row, to take inflation back to its 2% medium-term target. On this matter, the President also anticipated that they expect to further increase interest rates in the upcoming months. Secondly, Lagarde announced the Governing Council’s decision to set the remuneration of minimum reserves at the ECB’s deposit facility rate, aimed at making the remuneration of minimum reserves held by credit institutions with the Eurosystem more closely aligned to money market conditions. The lastmeasure changes the conditions for the third series of targeted long-term refinancing operations (TLTRO III), implemented by adjusting the applicable interest rates from 23 November while offering banks additional voluntary early repayment dates.
Last September, the euro area’s inflation rose to 9.9%, almost 8 percentage points above the 2% target. Energy price inflation, currently at 40.7%, is the main reason, with a substantial contribution from gas and electricity prices, as reported in the ECB press release on Monetary policy decisions. More recently, food price inflation also rose to 11.8% due to higher food production costs amid higher input costs. Inflation is expected to continue staying very high in the upcoming months due to supply bottlenecks, post-pandemic recovery in demand, soaring energy and food prices, and the uncertainty linked to such a context. Indeed, the data presented during the last Press Conference held in September revealed that the euro area economic growth was facing a substantial slowdown and was expected to stagnate in the following months. During the ECB Press Conference on 27th October, President Lagarde described the Governing Council’s view on economic development by saying that high inflation is continuing to push up costs for firms and reducing people’s real incomes, thus dampening spending and production, all compounded by the severe disruptions in the gas supply. Together with that, the overall global economic activity is also “growing more slowly, in a context of persistent geopolitical uncertainty, especially owing to Russia’s unjustified war against Ukraine, and tighter financing conditions. Worsening terms of trade, as the prices paid for imports rise faster than those received for exports, are weighing on incomes in the euro area’’. More precisely, the rise of the three key ECB interest rates by 75 basis points with effect from 2nd November increased to 2%, 2.25% and 1.5% of the interest rate on refinancing operations and interest rates on the marginal lending facility and deposit facility respectively.
Together with the rise of the ECB key interest rates, the ECB also decided to adjust the remuneration of the minimum reserve by setting it at the Eurosystem’s deposit facility rate (DFR) with effect from 21 December 2022, when the reserve maintenance period begins. Minimum reserves, a common monetary policy tool in central banking, are defined with the Regulation (EU) 2021/378 of the European Central Bank of 22 January 2021 on the application of minimum reserve requirements as the number of funds that credit institutions are required to hold in reserve accounts at their relevant national central bank over a maintenance period. At the end of the maintenance period, euro-area national central banks pay interest on the minimum reserves that banks hold with them. Until now, this compensation has been remunerated by the ECB’s interest rate on the main refinancing operations (MROs). Yet, the press release on the ECB remuneration adjustments of minimum reserves, published on the same 27th of October, contends that “under the prevailing market and liquidity conditions, the DFR better reflects the rate at which funds can be invested in money market instruments if not held as minimum reserves and the rate at which banks borrow funds in the money market to fulfil minimum reserves’’. This Is why minimum reserves will be remunerated at the DFR from 21st December, allowing for a better alignment with prevailing money market rates.
As to the third measure, the recalibration of TLTRO III was decided to ensure consistency within the broader process of euro area monetary policy normalisation. Indeed, as explained in the ECB press release on Monetary policy decisions, ‘‘during the pandemic this instrument played a key role during countering downside risks to price stability. Today, 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 normalisation process and to reinforce the transmission of policy rate increases to bank lending conditions’’. This way, TLTRO III will contribute to the transmission of the monetary policy stance supporting euro area inflation to timely return to the 2% medium-term target. Specifically, as announced in a detailed press release on the ECB recalibration of targeted lending operations published on the same day of the Governing Council meeting, the normalisation of financing conditions ‘‘will exert downward pressure on inflation, contributing to restoring price stability over the medium term. The recalibration also removes deterrents to early voluntary repayment of outstanding TLTRO III funds. Earlier voluntary repayments would reduce the Eurosystem balance sheet and, with that, contribute to the overall monetary policy normalisation’’. From 23 November 2022, the interest rate on all remaining TLTRO III operations will be indexed to the average applicable key ECB interest rates from that date onward, while the existing interest rate calculations will be maintained. Together with that, the Governing Council also decided to accompany such recalibration with three additional voluntary early repayment dates (one of which coincided with the start of the calculation method on 23 November 2022), allowing banks to terminate or reduce borrowings before maturity, if willing to do so.
On 2nd November, almost at the same time as the ECB’s new set of decisions, the Federal Reserve System (Fed) delivered its fourth consecutive increase in US policy interest rates by 75 basis points. Although the ECB has recently been lifting rates at a fast pace, it only started in July – way later than the FED – and investors expect both the ECB and the Fed to raise their policy rate to around 2.8% and almost 5% respectively by the middle of next year, according to Refinitiv data, in spite of the euro area inflation being higher than the US one (9.9% versus 8.2% respectively in September). In analysing the reasons behind this discrepancy between the two central banks, Swint points out that longer-term interest rates, determined by government bond yields, could shoot up much faster in some countries than others. According to Fairless and Dulaney, the ECB’s slower path compared to FED reflects Euro’s weaker recovery from the Coronavirus pandemic and the hit to activity dealt with by the war in Ukraine. Ultimately, concerns about the economic fragility in some euro area countries could also have played a role. Earlier in October, the leaders of France and Italy warned that if the ECB’s rate increases further, that could end up damaging the regional economy.
Sure thing, the ECB (third) increase of rates was expected, and so it was the announcement of further increases in the upcoming months, with the euro area inflation at almost 10%. German Finance Minister Christian Lindner welcomed the determination of the European Central Bank to raise interest rates again and expressed his full support to the ECB in doing everything in its power to combat high inflation. “Monetary policy and government fiscal policy must work hand in hand here and must not conflict with each other,” Lindner told reporters. Chief Investment Officer for Premier Miton, Neil Birrell, commented that “central banks everywhere will be looking at the economic data and will make decisions accordingly. They won’t want to overdo it and damage their economies more than they have to. But let’s be clear, inflation is the primary fear, not recession, and beating it is the most important battle to win.” As reported by Reuters, Global Head of Macro Research Carsten Brezeski bears a different opinion, defining the ECB’s new set of measures as “the sharpest and most aggressive hiking cycle ever,” and declaring that “normalising monetary policy is one thing but moving into restrictive territory is another thing. With today’s rate hike, the ECB has come very close to the point at which normal could become restrictive.”
Clearly, despite the progress made so far on the normalisation path in the euro area, ‘‘we are not done yet, but I stand by my comment: significant progress, withdrawing accommodation, more ground to cover’’, stated President Lagarde during the Q&A session of the ECB Press Conference held on 27th October and expressed the Governing Council’s determination to deliver price stability in the euro area, defined as the 2% inflation target in the medium term. Achieving price stability will also further require resilience and concerted efforts within the Eurozone. According to the ECB Monetary Policy statement, policymakers should encourage lower energy consumption, boost energy supply and design policies stimulating the euro area’s growth potential and supply capacity. National fiscal policies should do their role and prove their commitment in bringing down high public debt ratios, while a further significant contribution will also come by the implementation of the investment and structural reform plans under the Next Generation EU programme.
For the time being, in the President’s words : ‘‘We have to do what we have to do. A central bank has to focus on its mandate. Our mandate is price stability, and we have to deliver on that using all the tools we have, and selecting those that will be most appropriate and most efficient. […] When we fight inflation we think of our mandate, but we think about those people who are suffering most from inflation, and we will continue doing so’’.
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