ECB Hike Crosses Rubicon of Pain With Lagarde Warning of Hard Times

The prospect that euro-zone interest-rate hikes may be over will do little to soften the blow as the European Central Bank tightens the screws on a faltering economy.

(Bloomberg) — The prospect that euro-zone interest-rate hikes may be over will do little to soften the blow as the European Central Bank tightens the screws on a faltering economy. 

Thursday’s move to raise borrowing costs for a 10th consecutive time marks the entry into new territory for policymakers led by President Christine Lagarde as their visible hesitation points to awareness of how they’re dialing up the pain to pummel inflation.

The decision to bring the deposit rate to 4% came with the vague hope of bringing consumer-price growth below 2% at the very end of the ECB’s outlook in 2025. 

But the accompanying near-term message was far bleaker, as Lagarde admitted that growth will be “very, very sluggish” and forecasts acknowledged that the economy may even be on the verge of shrinking.

The danger for the ECB is that closed-door warnings from dovish officials that this was a hike too far prove correct, risking that the fingerprints of policymakers on a possible recession will expose them to populist criticism. Meanwhile financial markets are already betting on a reversal as soon as next June.

“This hike is not justified,” said Holger Schmieding, chief economist at Berenberg in London. “I’m afraid the ECB is still underestimating the economic downturn — the ECB is still too optimistic on growth.”

In their own words, officials “significantly” cut the outlook for expansion, with annual projections through 2025 all reduced. 

Their forecasts show the economy now flat-lining before eking out expansion of only 0.1% in the final quarter of this year — a profile that wouldn’t need much to go wrong to result in a recession.

That outlook was compiled before revised data revealed an even worse performance for the euro region in the second quarter, showing that the economy barely expanded. 

“The difficult times are now,” Lagarde told reporters, explaining that more tightening was needed “not because we want to force a recession, but because we want price stability.”

Such remarks haven’t tended to play well in countries such as Italy, which is feeling the impact of higher rates and just suffered a quarterly contraction. Thursday’s result was no different.

“This new decision — taken I believe by a majority, and therefore opposed by some — will not, I believe, help the economic recovery of Europe,” Industry and Made-in-Italy Minister Adolfo Urso was cited by Ansa as saying. “Germany is already largely in recession, and with it, other countries linked to the German system such as the Netherlands.” 

The problem for policymakers is that inflation — in their own words — is still anticipated to stay “too high for too long.” On both the headline gauge and an underlying measure that strips out energy and food, price growth is stuck above 5%.

Given that outlook, Peter Praet, a former chief economist of the ECB, reckons the 25-point rate hike was justified.

“The ECB is in a very difficult position because you have stagflationary pressures, so no growth — a little growth — and inflation,” he told Bloomberg Television. 

But Praet also reckons that the ECB is too optimistic on economic expansion — and pointed to how investor views have now shifted. 

Money markets brought forward bets on the timing of the first quarter-point interest-rate cut to June from July following Thursday’s hike. Almost three 25-basis-point reductions are priced across next year’s outcomes, the most since the start of the month.

“The hawks won the decision, but the doves won the market reaction,” said Karsten Junius, chief economist with Bank J Safra Sarasin in Zurich.

Lagarde was adamant that the prospect of a rate cut didn’t even pass the lips of officials during the meeting in Frankfurt, with attention now on maintaining the current level.  

“The focus is probably going to move a bit more to the duration, but it is not to say — because we can’t say — that now that we are at peak,” she said. 

With the market backdrop having shifted, the challenge for Lagarde and her colleagues will be to convince investors that they really are willing to stay the course with tight monetary policy.

That may even be one reason why rates had to rise again this month, according to Skylar Montgomery Koning, director of macro strategy at Globaldata TS Lombard. 

“It’s very much an environment of stagnation, and the ECB is finally recognizing that,” she told Bloomberg Television. “I think the thought process this month was, either we hike now, or maybe we lose the opportunity to do a final hike because the data deteriorates so much — and we want to signal to the market that we still are going for higher for longer.”

–With assistance from Alexander Weber, Alix Steel, James Hirai, Guy Johnson, Flavia Rotondi and Alessandra Migliaccio.

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