Policymakers at the European Central Bank are reconsidering raising interest rates after the banking turmoil

  • Core inflation in the eurozone fell sharply in March, but core inflation – which excludes volatile energy, food, alcohol and tobacco prices – rose to an all-time high.
  • The banking crisis in March caused some ECB policymakers – such as Austrian National Bank Governor Robert Holzmann – to rethink their next moves.
  • Visco called for patience in assessing the path of the ECB’s rate hike, but said policymakers will scrutinize the data for signs that core inflation is falling and the bank’s medium-term inflation target of 2% is in sight.

A sign for the European Central Bank (ECB) outside the bank’s headquarters in Frankfurt, Germany, on Thursday, February 2, 2023.

Alex Krause | bloomberg | Getty Images

European Central Bank policymakers are reconsidering the path of rate hikes in light of last month’s banking turmoil, but remain committed to reining in core inflation.

Contagion fears triggered by the collapse of the US-based Silicon Valley bank in early March led to the collapse of several other regional US lenders, culminating in a bailout of Credit Suisse by Swiss European giant UBS.

Although panic at the time sent investors and depositors fleeing the global banking sector, the market has since calmed amid the consensus that bank failures were the result of particular fragility in business models, rather than a systemic problem.

The European Central Bank raised interest rates by 50 basis points in mid-March at the height of the banking turmoil, despite some calls for the central bank to pause.

But this week, several members of the Governing Council pointed to the risk of an economic spillover as interest rates continue to rise in an effort to tackle inflation.

The headline inflation rate in the Eurozone fell significantly in March to 6.9% annually, largely due to lower energy prices. However, core inflation — which excludes volatile energy, food, alcohol and tobacco prices — rose to an all-time high of 5.7%.

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The events of the past month have caused some ECB policymakers – such as Austrian National Bank Governor Robert Holzmann – to rethink.

He had previously suggested that the ECB’s Governing Council might need to consider up to four more interest rate increases, starting with a 50 basis point increase, at its next meeting in May.

But he told CNBC on Thursday that “things have changed” since those comments two months ago, and that the central bank will need to closely assess the situation after the next meeting.

“It’s absolutely certain that what we’ve seen with the banking crisis in the United States and with Switzerland, has led to changes in expectations and if expectations change, we have to change our views,” Holzmann told CNBC at the IMF’s spring meetings in Washington. Capital

He added that persistent core inflation still needs to be factored in, but it is “not the only part” that matters, with financial conditions tightening markedly and access to credit for households and businesses diminishing.

“What also matters is the situation in the financial markets. If the situation in the financial market firms increases, and it becomes more difficult for households and firms to obtain credit, this must be taken into account. [rates must rise] It depends a lot on what the environment tells us at this time.”

This cautious tone was echoed by fellow board member Ignazio Fiesco.

The Governor of the Bank of Italy said that the financial turmoil – although not yet felt in the eurozone, where banks are mostly well capitalized and have ample liquidity – was one of several factors adding downside risks to the economic outlook.

“The Italian banking sector is doing very well, the European banking sector is doing very well, in terms of the disruptions that we’ve seen – it’s mostly related to the particular banks’ business models that have been affected,” Visco said.

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“This is privacy, but there could be contagion for other reasons. Social media works in ways that are now difficult for us to understand.”

Underlying inflation concerns

Visco called for patience in assessing the path of the ECB’s rate hike, especially as credit conditions “have become significantly tighter.” But he said policymakers will scrutinize the data for signs that core inflation is declining and that the bank’s medium-term inflation target of 2% is close.

“As a matter of fact, if you look at the credit data, it shows that the growth rate has gone from more than 10% in late summer to zero, negative in real terms now, so we are tightening. We have to wait for monetary policy delays,” he said. The recent political moves may take between a year and 18 months to fuel the eurozone economy.

Other ECB Governing Council members unanimously identify core inflation as the key measure for the ECB in determining the pace of interest rate hikes, and the stage at which it can take on the brakes.

Gediminas Simkus, president of the Bank of Lithuania, said the apparent stickiness of core inflation was a major concern, and called for “bold measures”.

“We need these actions in July, in September we need to continue, and that’s my approach. We need decisions now for us to avoid stronger decisions in the future,” he said, adding that there should be a 75 basis point increase on the schedule, depending on the data.

As Edward Scicluna, Governor of the Central Bank of Malta, said there was “still some way to go” the ECB in its struggle with rate increases.

“We can’t do anything about energy prices, but we’re very upset to see inflation start to ease, that wage earners are going to say ‘oh, we don’t think it’s going down so we’re going to ask for pay increases.’ Same for companies. So yeah we’re worried about That core inflation has not peaked yet,” Sciclona said.

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He added that the size of any interest rate hike in the future would be difficult to predict given economic developments, including concerns about the banking system, but noted that the fact that discussions about a pause or slowdown is an indication that interest rates are nearing a peak.

“It gets more difficult each time. This is a good sign that the end of the tunnel is not far away,” he said.

Although the eurozone economy has so far avoided recession, concerns persist about the impact of further monetary tightening on growth.

The Governor of the Bank of Latvia, Martiš Kazak, highlighted this on Thursday, stating that the 20-member bloc is “not out of danger yet” and that recession risks are “non-trivial”.

“Inflation is still high. There is a risk of some financial instability – so far, very good in Europe, and there is some reason to be confident about it, but we have to watch,” he told CNBC.

“However, we also see that the labor markets have been very strong, much stronger than expected, which leads to the situation where rates have to go up more to tame the problem of inflation, and that could have some implications for the pockets of weakness that we saw in some sectors of the market. It also plays its part.”

Asked about balancing the need to control inflation with the risk of overtightening and putting more downward pressure on growth, Kazak called on policymakers to remain focused on the inflationary mandate, and said he saw “no reason to slow down anytime soon.”

“The risks of not doing enough in terms of raising interest rates are, in my view, much higher than doing too much,” he said.

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