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08 Sep

E.C.B. Raises Interest Rates to Tame Inflation

The European Central Bank raised interest rates sharply on Thursday as policymakers battle to bring down record-high inflation driven by soaring energy prices, and warned of a significant economic slowdown ahead.

The bank increased its key rates by three-quarters of percentage point, the biggest rise since 1999, in the very early days of the eurozone. Around the world, central banks have been pushing rates higher in larger increments to send strong signals to consumers and businesses that they will bring stubbornly high inflation back down, and won’t be deterred by economic pain in the process.

Policymakers in Europe are facing a particularly difficult economic challenge, fighting rising inflation stoked by an energy crisis that threatens to cause a recession, with the prospect of steep energy cutbacks and even the rationing of natural gas this winter.

The E.C.B. said it expected a “substantial slowdown” in growth in the 19 countries using the euro, “with the economy expected to stagnate later in the year and in the first quarter of 2023.” Its projections for economic growth for the remainder of the year and into the next were downgraded, but Christine Lagarde, the president of the central bank, stressed that further rate increases, which dampen demand by making borrowing more expensive, were necessary in the coming months.

“We took today’s decision, and expect to raise interest rates further, because inflation remains far too high,” Ms. Lagarde said in a news conference on Thursday. “Price pressures have continued to strengthen and broaden across the economy.”

Thursday’s rate increase, which took the E.C.B. deposit rate from zero to 0.75 percent, was “a signal to markets that the central bank is serious about regaining its inflation-fighting credentials and that is it willing to accept costs in terms of lower growth to ensure price stability,” economists at Morgan Stanley wrote in a note to clients.

The E.C.B. is trying to ensure that high inflation doesn’t become entrenched as workers demand higher pay and businesses raise prices to cover ever-higher costs.

But inflation has proved much more persistent than the central bank had expected. Six months ago, it projected that inflation would average 5.1 percent this year and fall back toward its target of 2 percent next year. On Thursday, it raised its forecast to 8.1 percent this year, 5.5 percent in 2023 and 2.3 percent in 2024.

Ms. Lagarde conceded that the E.C.B. had underestimated the impact of Russia’s war in Ukraine on inflation. “Yes, we made forecasting errors,” she said. “I take the blame.”

In July, the central bank raised interest rates for the first time in more than a decade, implementing a larger-than-telegraphed increase of half a percentage point. Since then, the eurozone’s annual inflation rate rose to 9.1 percent in August, a fresh record since the creation of the euro, up from 8.9 percent the previous month.

Driving the increases has been the price of natural gas, which has soared to almost 12 times higher than what it was at the start of 2021, after President Vladimir V. Putin of Russia weaponized his country’s energy exports, restricting the flows of oil and gas to Europe in retaliation for economic sanctions imposed by the European Union.

While the central bank did not forecast a recession, it noted that there is a risk of a complete shutdown of Russian gas supplies and energy rationing that would lead to a recession next year. “It’s a really dark downside scenario,” Ms. Lagarde said.

E.U. ministers are preparing to intervene in the energy market when they meet in Brussels on Friday to rein in prices. They will discuss strategies that could include price caps, mandatory cuts in usage and decoupling electricity from the price of gas — a factor currently driving the jump in the price of power.

Ms. Lagarde welcomed the intervention, saying it was up to politicians, not central bankers, to tackle the energy crisis. “Monetary policy is not going to reduce the price of energy,” she said.

With inflation in the eurozone ranging from 6.5 percent in France to 25.2 percent in Estonia, some policymakers have argued that keeping inflation expectations in check requires strong action.

Others have suggested that an economic slowdown will weaken inflationary pressures and allow the E.C.B. to take more moderate action. On Thursday, Ms. Lagarde said the decision to increase the rate by three-quarters of a point was made unanimously, despite “different views around the table.”

Adding pressure on the central bank to act is the weakening euro. The currency has fallen to 99 U.S. cents, its lowest level in two decades, after a decline of more than 12 percent this year. With a weaker currency, the region will import more inflation as it has to pay more for the goods it buys from abroad, which includes energy. As Ms. Lagarde spoke at the news conference, providing more context to the rate increase and economic forecasts, the euro weakened further, European stocks declined and government bond yields rose.

As inflation has soared around the world, the E.C.B. was one of the last major central banks to raise interest rates. Thursday’s move matched the size of increases at the latest meetings of the Federal Reserve and the Bank of Canada, showing that the eurozone’s central bank had joined its international peers in moving forcefully to tame inflation.

The E.C.B. initially held back on raising interest rates, but ended its massive bond-buying programs. Now, it is raising interest rates to “normalize” its policy stance, without becoming restrictive and slowing the already fragile eurozone economy. In comparison, the Fed has been steeply raising interest rates to cool demand in an overheating U.S. economy.

For the E.C.B., the economic consensus has shifted to the argument that the high level of inflation calls for forceful policy action, regardless of the cause of price pressures. But with growing evidence that the eurozone is getting weaker as high energy costs and supply chain disruptions dampen activity, analysts say there is a shrinking window for action.

Hetal Mehta, an economist at Legal & General Investment Management, wrote in a note that “there will be no letup in the policy dilemma the E.C.B. faces over a difficult autumn and winter.”

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