The European Central Bank has raised its key interest rates by an unprecedented 0.75 per cent on Thursday and signalled further hikes, prioritising the fight against inflation even as the bloc's economy is heading for a likely winter recession.
With inflation at a half-century high and approaching double-digit territory, policymakers are worried that rapid price growth could become entrenched, eroding the value of household savings and setting off a hard-to-break wage-price spiral.
Following up on its July rate hike, the ECB raised its deposit rate to 0.75 per cent from zero and lifted its main refinancing rate to 1.25 per cent, their highest levels since 2011, with further moves anticipated in October and December.
"This major step frontloads the transition from the prevailing highly accommodative level of policy rates towards levels that will ensure the timely return of inflation to the ECB’s 2 per cent medium-term target," the ECB said in a statement.
Policymakers had for weeks oscillated between a 50 and a 75 basis-point increase, but another jump in both headline and underlying inflation appears to have settled the debate as figures indicate that price growth is now seeping into the broader economy, making it even harder to root out.
Indeed, the ECB raised its inflation projections once again, lifting the 2023 outlook to 5.5 per cent from 3.5 per cent and putting the 2024 rate at 2.3 per cent, above its 2 per cent target.
Despite the frontloading, further rate hikes are likely, the ECB said: "Over the next several meetings the Governing Council expects to raise interest rates further to dampen demand and guard against the risk of a persistent upward shift in inflation expectations."
Going into the meeting, conservatives feared that anything other than an outsized move would signal that the ECB was not serious about its inflation-fighting mandate - officially its sole objective.
That risked pushing up already high long-term inflation expectations, which would signal a loss of confidence in the ECB and raise questions about the bank's inflation-targeting framework.
Recession fears
Timid action also risked weakening the euro and boosting inflation further through more expensive energy imports.
The euro has been languishing around parity against the dollar for weeks, not far from a two-decade low hit earlier this month.
That means more expensive exports of everything from oil to cars, which then raises prices for consumer.
Policymakers have also made the case for frontloading rate hikes partly to send a strong signal about the central bank's inflation-fighting commitment and partly to get most of the hikes done before the onset of a recession becomes evident.
With high energy prices sapping purchasing power, a downturn is essentially inevitable.
However, monetary policy is mostly powerless against a supply-shock driven downturn, firming the argument for hikes even if the economy suffers.
Some policymakers are now openly talking about a recession, and the ECB's new projections also show sharply lower growth in the coming years.
Still, a shallow recession may even be useful, some argued, as the bloc's labour market is increasingly tight and a downturn could provide relief to firms now struggling to find workers.
The bank sees the euro zone economy expanding by 3.1 per cent this year and 0.9 per cent in 2023. While this year's growth projection was lifted a touch, it was lowered sharply for 2023.
