ECB surprises with bigger rate hike than expected to combat inflation

The European Central Bank raised interest rates for the first time in more than a decade as its governing council took steps to keep inflation under control.

The central bank raised its three key interest rates by 50 basis points each. The marginal lending facility, which provides overnight credit to banks from the eurosystem, increased to 0.75%. Interest rates on the main refinancing operations of the eurosystem, which provides the bulk of liquidity to the banking system, is now at 0.5%. The interest rate on the deposit facility, used by banks to make overnight deposits, increased to zero.

The governing council took a "larger first step on its policy rate normalization path than signaled at its previous meeting" in part due to an updated assessment of inflation risks, said a news release outlining the decision. In June, the ECB committed to an increase of 25 basis points in July, with a further hike signposted for the fall. The ECB adjusts monetary policy to reach its inflation target of 2% over the medium term.

Eurozone inflation hit 8.6% in June, ECB President Christine Lagarde said in a news conference Thursday.

Summarizing the governing council's risk assessment for the eurozone, Ms. Lagarde said: "Inflation continues to be undesirably high and is expected to remain above our target for some time. The latest data indicates a slowdown in growth, clouding the outlook for the second half of 2022 and beyond. At the same time, this slowdown is being cushioned by a number of supportive factors."

She also said a "prolongation of the war in Ukraine remains a source of significant downside risk to growth, especially if energy supplies from Russia were to be disrupted to such an extent that it led to rationing for firms and households. The war may also further dampen confidence and aggravate supply-side constraints, while energy and food costs could remain persistently higher than expected. A faster deceleration in global growth would also pose a risk to the euro area outlook," she said.

The ECB also unveiled its Transmission Protection Instrument, an addition to its "toolkit" that will ensure its monetary policy stance is transmitted smoothly across all eurozone countries, Ms. Lagarde said.

The TPI "can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area," the news release said. "The scale of TPI purchases depends on the severity of the risks facing policy transmission."

Under the TPI, the eurosystem can make secondary market purchases of securities issued in markets that are "experiencing a deterioration in financing conditions not warranted by country-specific fundamentals," a separate news release on the TPI said. The aim is to counter risks to the transmission of the ECB's monetary policy into the eurozone states. The scale of purchases under the TPI would depend on how severe the those risks are.

The euro was up 0.2% against the dollar in the hours after the decision was unveiled, to $1.02, after initially advancing by about 1%.

Money managers said they expect further hikes to interest rates through the end of the year, while warning the ECB must also navigate a number of market stresses, such as indebtedness in several countries and political uncertainty in Italy following the resignation of Prime Minister Mario Draghi.

Gurpreet Gill, macro strategist, global fixed income at Goldman Sachs Asset Management, said in an emailed comment that the firm expects a hike of 50 basis points at the September meeting, followed by two 25-basis-point rises in November and December.

"Should growth slow significantly, the ECB may take a more gradual approach to its exit from ultra-easy monetary policies. And a material gas supply shock could yet interrupt — though not derail — its rate hiking path," Ms. Gill said.

Seema Shah, chief strategist at Principal Global Investors, said in a separate emailed comment: "The ECB's era of negative rates has finally come to an end, and with quite a bang — but it's not against a backdrop of strong economic growth and certainly not accompanied by celebratory smiles. Quite the contrary. The ECB is hiking into a drastically slowing economy, facing a severe stagflationary shock that is quite beyond its control, while also facing an Italian political crisis which presents a difficult sovereign risk dilemma. There is no other developed market central bank in a worse position than the ECB."