Eleven years is not a long time on the capital markets. And 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.
A lot was different politically too. In 2012, for example, the euro zone threatened to break up due to the debts of southern countries. In 2014 Russia annexed Crimea. In 2016, the British voted for Brexit. That same year, Americans made Donald Trump their president.
Now, for the first time since 2011, the ECB is about to make money noticeably more expensive. At her press conference, Central Bank President Christine Lagarde left no doubt that the institution will raise interest rates in July.
“On the one hand, the decision is a turning point, on the other hand, the ECB missed the opportunity to send a sign of determination,” says Dirk Chlench, economist at LBBW.
According to the statute, the ECB’s primary task is to keep the value of money in the euro zone stable. With an inflation rate of over eight percent, as is currently being experienced in monetary union, there can no longer be any question of that.
And the external value of the European currency has recently suffered significantly. In mid-May, the euro had fallen below $1.04. That was the lowest level in almost two decades.
The plan is to raise the rate for the main refinancing operations, as the key rate is called, to 0.25 percentage points in July. After the summer break in September, the next rate hike is due.
If inflation does not fall significantly by then – which is likely – the rate hike in September could be as much as 50 basis points. According to forecasts, the rate could be one percent by the end of 2022. In Frankfurt/Main there is talk of normalization.
While the ECB is proceeding cautiously, some say hesitantly, other central banks around the world have already tightened monetary policy. In the US, the Fed has now raised interest rates to 1 percent, as has the Bank of England. Canada has 1.50 percent, South Korea even 1.75 percent.
Many national economies are likely to make central bank money more expensive this year at a similar rate as the 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 of ultra-cheap money is over.
“The ECB has officially ended the long era of unconventional monetary policy,” says Carsten Brzeski, chief economist for the euro zone at ING. That includes not only the prime rate. In addition to the announced rate hike, the bond purchase program that artificially depressed interest rates on long-dated government bonds and other fixed-income securities will also be discontinued. It expires on July 1, 2022.
Negative deposit rates for banks will also be reduced. But whether the central bank is really willing to quickly push inflation down to two percent – where its official target is – remains to be seen. Lagarde spoke of achieving the goal “in the medium term” – a flexible term. “It’s not a step, it’s a journey,” is how the supreme currency guardian described the fight against inflation.
According to its own statements, the ECB can do little to change the high inflation in the short term. In fact, the monetary authorities are now even anticipating inflation of 6.8 percent for the year as a whole, which is significantly more than in the previous forecast.
Sustained price increases and the associated fluctuations are dampening the mood among businesses and consumers. The cautious approach of the currency watchdogs also means that savers still have to be patient. It will be months before interest is paid again on savings accounts and overnight money.
However, the central bankers’ policy shift has already had one effect: capital market interest rates have started to move. “With the turnaround in interest rates now in fact fixed, the yields on government bonds in the euro countries have risen,” notes Ulrich Stephan, chief investment strategist at Deutsche Bank.
Ten-year Bunds, which many take as a yardstick, dropped 1.4 percent this week – the most since 2014. The heavily indebted southern states of the euro zone have to pay significantly more interest. In the meantime, ten-year debt securities issued by the Italian state yielded 3.7 percent.
Should these interest rate differentials widen – stock market traders speak of risk premiums or “spreads” – this could result in new tensions in the euro zone. For a country like Italy, whose liabilities account for 160 percent of economic output, rising financing costs can quickly become a problem.
The soaring spreads threatened to blow up the pan-European capital market. In 2011/2012 this was the reason for the ECB to enter the cheap money policy.
Lagarde tried to calm concerns at the press conference: “If necessary, we will either use existing customized instruments or new instruments.” The central bank will counter fragmentation of the European capital market. The Frenchwoman left it open which instruments these are exactly.
It can be assumed that dealing with growing spreads will shape the coming years. This raises the question of how long the ECB can sustain the normalization of interest rates.
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