First time rate increase in 11 years takes market by surprises

Durrant Pate/Contributor

The European Central Bank (ECB) today (July 21) announced an increase in interest rates, the first time in 11 years.

The move has taken the market by surprise with a larger than expected hike, in an attempt to cool rampant inflation in the Euro Zone. The ECB, which is the central bank of the 19 European nations that share the Euro currency, surprised markets raised its benchmark rate up by 50 basis points, bringing its deposit rate to zero.

However, traders had expected a smaller hike of 25 basis points knowing that the ECB had previously signaled it would be increasing rates in July and September, as consumer prices keep surging. The Frankfurt based institution had kept rates at historic lows, in negative territory since 2014, as it dealt with the region’s sovereign debt crisis and the coronavirus pandemic.

ECB statement on rate hike

In a statement today, the ECB said: “The Governing Council judged that it is appropriate to take a larger first step on its policy rate normalisation path than signalled at its previous meeting.”

Continuing, the ECB argued that the rate hike “will support the return of inflation to the Governing Council’s medium-term target by strengthening the anchoring of inflation expectations and by ensuring that demand conditions adjust to deliver its inflation target in the medium term”.

The ECB’s inflation target is two per cent. A first reading for inflation in June showed a record high of 8.6 per cent. However, some investors are skeptical over the ECB’s actions as they predict a recession later this year.

The euro rose to a session high on news of the more aggressive rate hike to trade at US$1.0257.

Speaking after the decision, ECB President Christine Lagarde sought to justify the decision, arguing “inflation continues to be undesirably high and is expected to remain above our target for some time. The latest data indicate a slowdown in growth, clouding the outlook for the second half of 2022 and beyond”.

Anti-fragmentation tool

In the meantime, today, investors kept a keen eye on details regarding the ECB’s new anti-fragmentation tool, which is aimed at supporting those nations with lofty debt piles and high borrowing costs, like Italy. The ECB called this new tool, Transmission Protection Instrument (TPI).

The new tool can be activated to counter “unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area”.

According to the ECB, “the scale of TPI purchases depends on the severity of the risks facing policy transmission”.

Details released later showed that the tool could be used where countries experience surging borrowing costs that were deemed not to be their fault. The main proviso was that they would stick to “sound and sustainable fiscal and macroeconomic policies”.

This becomes particularly important in the context of Italian politics, where snap elections are now expected to take place in the fall after Prime Minister Mario Draghi resigned this morning. A credible government that sticks to the targets agreed with the European Commission will be critical if it is to benefit from the new tool.

The ECB also stated that purchases would focus on public sector assets with a remaining maturity of between one and 10 years.

“Purchases of private sector securities could be considered, if appropriate,” the institution added.