The big dilemma facing the European Central Bank this week | Economic news

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It was a surprising and dramatic moment when, in July, the European Central Bank raised interest rates for the first time in 11 years.

Not the time to rate hike – the bank’s president, Christine Lagarde, had prepared the markets for a rise in June – even if it was an event on which few would have bet at the start of the year.

No, it was the scale of the increase, which brought the main ECB interest rate down to zero from -0.5%, where it had been since September 2019. This is a larger increase than what most economists and market participants expected.

Markets look less likely to be caught off guard again when the ECB’s main decision-making body, the Governing Council, meets again on Thursday.

A hike taking the ECB’s main key rate to 0.75%, only the second time in its history that it has raised interest rates by three-quarters of 1%, is now priced in by investors. Another half-point rise, like in July, is the least of expectations.

The reason for this is that, like in the UK, inflation in the Eurozone is rampant.

Although slightly lower than July’s headline rate of 10.1% in the UK, as measured by the consumer price index, the estimated eurozone headline rate of 9.1% for August is not not far behind.

In a number of euro area countries, it is significantly higher. For example, Eurostat, the main statistical agency of the EU, estimates that inflation in August was 10.5% in Belgium, 13.6% in the Netherlands, 11.1% in Greece and 10.3% in Spain.

In the Baltic trio of Latvia, Estonia and Lithuania, it is north of 20%. Without France – whose expected rate is only 6.5% because Emmanuel Macron capped energy prices at the expense of French taxpayers – the average inflation rate in the eurozone would be even closer from that of the United Kingdom.

The ECB therefore has little choice.

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President of the European Central Bank Christine Lagarde

Senior bank officials, such as the German representative on its board, Isabel Schnabel, have spoken increasingly strenuously about the need to further reduce inflation.

At the recent meeting of world central bankers in Jackson Hole, Wyoming, Ms Schnabel gave a speech in which she spoke of the “sacrifice” needed to curb inflation.

As the economics team at investment bank Goldman Sachs told clients on Friday last week: “The inflation picture has deteriorated further since the July meeting…[there has been] a further widening of underlying price pressures and slightly higher inflation expectations. The new staff projections should therefore show a strong improvement over the 2022-23 inflation forecast.

“Recent comments from the ECB have been hawkish, with executive board member Schnabel arguing in Jackson Hole that the ECB needs to ‘act forcefully’ to ‘bring inflation back to target quickly.’ number of national central bank governors have said that a 75 basis point hike should be considered next week.

“While other members of the Council – including a member of the Board of Directors [Philip] Lane – advocated a steady pace of increases, the pullback against calls to intensify the tightening was limited.

“While this is not a done deal, we therefore believe that a 75 basis point hike next week is more likely than another half point step.

“Given market prices, a 50 basis point hike would be a significant dovish surprise which we believe would be difficult to communicate in light of the strong inflation data.”

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The weakness of the euro is an inflationary risk for the ECB

An interest rate hike of this magnitude, however, would be anything but painless for the ECB.

The eurozone economy, like that of the UK, is on the verge of recession thanks to soaring wholesale energy prices caused by the Russian invasion of Ukraine.

While GDP growth in Spain and Italy during the second quarter of the year was better than expected, thanks to a good recovery in tourism in these countries for the first time since the pandemic, GDP growth in Germany , the largest and most important economy in the Eurozone, was disappointing.

The latest data from S&P Global’s Purchasing Managers Index (PMI) survey, a key forward-looking indicator, suggests that Germany’s services sector suffered a contraction in activity in August for the second month in a row, as new business entries down for the third consecutive month.

Germany’s huge manufacturing sector has also contracted over the past two months. The latest official data from Berlin, released on Tuesday, showed that German industrial orders fell in July for the sixth month in a row.

And in France, the second largest economy in the Eurozone, the services sector is losing momentum and is currently close to stagnation levels. The consensus among economists is that the Eurozone is poised for three straight quarters of GDP contraction.

Thus, the Governing Council of the ECB will be attentive to the risks of too rapid a tightening of monetary policy, even if certain indicators have been quite encouraging lately. For example, partly reflecting labor market tightness seen in other countries such as the US and UK, the eurozone unemployment rate fell in July to a record low of 6.6. %.

The biggest question for the markets, therefore, is where are interest rates going at the top of the euro zone – what is known as the “terminal rate” in the jargon.

Right now, the bet is around 1.75%, which is considerably lower than where the Bank of England’s key rate is expected to peak.

But make no mistake, the ECB will be just as anxious as the Bank will be about the risks of raising interest rates in the midst of a recession.

This is something that hasn’t happened in the UK since the 1970s – and it will be uncharted territory for the eurozone.

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