ECB faces moment of truth on interest rates

As the ECB's policymakers meet on Thursday to decide on the future direction of monetary policy, they are confronted with some serious challenges. Inflation in the eurozone has spiked to multiyear highs, while the single European currency, the euro, has sunk to lows last seen two decades ago. At the same time, the euro area's biggest debtor nation, Italy, is in the midst of a formidable political crisis.

Against this backdrop of bad news, ECB President Christine Lagarde announced in June that the central bank of the eurozone was planning to implement its first interest rate hike in 11 years: an increase of its benchmark interest rate by 25 basis points, likely to be followed by another 50-point hike in September.

As the days of negative interest rates seem to be over, several commercial banks in the euro area have already stopped charging their clients for the money they hold with them — in Germany, for example, 50 commercial lenders have done so, with more expected to follow in the next few weeks.

ECB trailing behind

The interest-rate path chosen by the ECB, however, isn't all that clear yet and is open to much speculation in the world of finance. Gertrud Traud, chief economist at German regional lender Helaba, said the central bank was "too late" in changing its policy. In view of the "historic high inflation" of 8.6%, the situation is "precarious," she told DW.

"Everywhere in the world central banks are raising interest rates. Now the ECB has to prove that it's taking its mandate seriously and begin fighting inflation."

But the speed and magnitude of the necessary rate hikes are controversial, even within the ECB's rate-setting Governing Council. Bundesbank President Joachim Nagel, who represents Germany on the Council, said he would prefer pushing euro rates into "restrictive" territory, meaning high enough to slow activity in the eurozone economy. A so-called policy hawk, Nagel believes in a tightening of financial conditions to cool down inflation.

Those who want to keep the ECB's monetary taps open, the so-called doves, are advocating for a softer rate-hike path, warning of an emerging risk of a recession, notably as a result of the Ukraine war. Many ECB watchers share that view.

More than 25 basis points? 

For Karsten Junius, chief economist at Bank Safra Sarasin in Switzerland, an increase of 50 percentage points should be the order of the day at the ECB. He told DW that the central bank should even drop its forward guidance, referring to ECB announcements aimed at managing financial market expectations long before it makes a policy decision. 

Traud, though, believes it's important at the moment for policymakers to communicate to the market that they will continue raising rates, even if the upcoming hike would only be modest. The bank's mandate is to keep inflation in check and protect the value of the euro, she said, which is why the ECB's inflation goal of around 2% must be maintained.

But "normalizing" eurozone interest rates isn't an easy task presently. If the ECB tightens monetary conditions too much, this would kill off the nascent economic upswing in Europe, and "won't help drive down energy prices," said Martin Lück. The chief economist at BlackRock Germany told DW that "prices for goods and services must be reined in with other means."

What if Russian gas stops flowing?

Fears of a recession are rife in the eurozone. There are worries that Russia might choose to stop gas supplies to Europe in the wake of regular maintenance of its Nord Stream 1 pipeline due to end on Thursday — the very same day ECB policymakers are meeting in Frankfurt.

Lück argued that interest-rate normalization would require bringing ECB rates in line with the so-called neutral rate of interest — the rate that ensures the economy doesn't slip into a recession while keeping inflation constant. This rate, however, needs complicated economic models to arrive at. Where the neutral rate for the eurozone currently stands is "difficult to ascertain," Lück added.

The ECB is also under mounting pressure because of the widening rate gap, the so-called spread, between interest rates in the United States and Europe. After US inflation accelerated to 9.1% in June, the US Federal Reserve (Fed) is likely to hike key interest rates by another 75 basis points, adding to its aggressive hikes in recent months. The Fed's hawkish policy has weighed on the euro-dollar exchange rate, bringing it down to parity this month.

And finally, all eyes are on the situation in Italy, where the likely resignation of Prime Minister Mario Draghi amid a government crisis isn't making life for the ECB any easier. It remains unclear if the former ECB boss will stay in power, and the prospect of early elections in the eurozone's third-largest economy in October is keeping financial markets on edge.

If any of Italy's euroskeptic parties were to win the elections, this would create "massive turbulence" in the bond market, Edgar Walk from Bankhaus Metzler told DW.

Mindful of Italy's massive sovereign debt and slow growth, ECB observers are also watching for clues as to a new instrument from the bank's monetary policy toolkit, the so-called anti-fragmentation program. This is aimed at limiting divergence in borrowing costs between the eurozone's strongest and weakest countries.

The program may come sooner rather than later. The gap between Italian and German benchmark 10-year bond yields on Friday last week yawned to its widest in a month, indicating that investors were demanding a higher premium to hold riskier eurozone debt.

This article was originally written in German.