The European Central Bank has decided to raise interest rates by a quarter-point to 3.5%, with plans for further increases in July. The bank’s decision comes as it raises its inflation forecast and lowers its growth predictions for the next three years.
Christine Lagarde, ECB President, stated that there is still more progress to be made and borrowing conditions will likely be tightened again at the next policy meeting unless there is a significant change in economic data.
The bank warns that inflation is expected to remain high for an extended period, not reaching its 2% target until 2025. Economists describe the rate hike as a “hawkish hike” and the ECB’s new forecasts as “decidedly stagflationary.”
Following the announcement, the yield on the two-year German government bond and the euro both experienced slight increases.
This rate rise contrasts with the US Federal Reserve’s decision to pause rate increases. Inflation in the eurozone is now higher than in the US.
Eurozone inflation has seen a decrease from its peak of 10.6% in October, primarily due to lower energy costs. However, the ECB is concerned that prolonged high inflation may lead to a cycle of increasing wages and costs, thus maintaining elevated price pressures.
ECB data published last week shows a 5.2% increase in pay per eurozone employee in the first quarter compared to a year ago. The bank has raised its forecast for core inflation, attributing it in part to the strength of the labor market.
Former ECB executive Jörg Asmussen expects rate-setters to continue tightening for a while. He suggests that markets may need to adjust their interest rate expectations, particularly regarding the timing of the first rate cut.
Equity markets reacted negatively to the central bank’s decision, with France’s Cac 40 and Germany’s Dax index trading lower.
Although facing weak economic growth and experiencing a slight contraction in recent quarters, the eurozone economy has proved more resilient than initially expected.
The ECB has slightly revised its growth projections, with expectations of a 0.9% expansion this year, 1.5% in 2024, and 1.6% in 2025.
The central bank has also confirmed its intention to halt reinvesting the proceeds of its asset purchase program from July, which is predicted to reduce its balance sheet by €25 billion per month.
Additional reporting by Philip Stafford and George Steer in London
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