The European Central Bank (ECB) continues to push forward in its battle against rising prices. The governing council on Thursday decided to raise the euro-area policy rate by 0.75 percentage points, bringing the key rate to 2.0 percent—the highest level since January 2009. Mortgage costs, loan rates, and financing for households and businesses are set to move higher as the trajectory of tightening remains intact.
The decision aligns with market expectations and the consensus of analysts who had anticipated another substantial hike after the prior move in September. That earlier increase stood at 0.75 points, marking the steepest rise in 23 years for the institution. By the end of July, the ECB began a cycle of monetary tightening with a 0.5 percentage point increase, the largest in more than a decade and double what many had projected for June.
With this third consecutive major rise in official rates, the governing council signaled it would persist in tightening monetary policy despite the dampening effect on already sluggish economic activity. Inflation remains stubbornly high and is expected to stay above target for the foreseeable future, according to the central bank’s outlook [citation].
End of free financing
The ECB also announced steps to shrink its balance sheet, which will tighten liquidity conditions for economic agents. The central bank will phase out ultra-cheap financing that had supported banks during the pandemic, making loans more expensive for customers and cooling demand. These liquidity operations will now be priced at the average of the three main official rates (2.0%, 2.25%, and 1.5%). Between June 2020 and last June, the rate had moved from -1% to 0% and then to 0.75% in September. [citation]
This change ends the period of ultra-cheap funding. Banks can no longer count on free financing from the ECB and will need to fund their activities at market-based rates, shifting the deposit facility back to 1.5% after the recent rise. The institution also gave banks more flexibility to repay this debt and required that minimum reserves held at the central bank be adjusted up to the level of the new deposit facility rather than the prior general rate of 2% [citation].
Without ceasefire
The ECB moved later than its peers, such as the U.S. Federal Reserve, but accelerated its pace as inflation surged and outpaced expectations. The war in Ukraine contributed to the surge, pushing prices higher and delaying any sense of relief for monetary authorities. The central bank has framed the tightening as a temporary response to a one-off shock, yet the persistence of price pressures has kept policy on a tightening course [citation].
How will the ECB rate hike affect mortgages?
The euro area CPI reached a multi-month high in September, climbing to 10.0 percent year over year, well above August’s 9.1 percent. The ECB has since revised its inflation projections higher, with an expectation of about 8.1 percent on average for 2022, 5.5 percent in 2023, and 2.3 percent in 2024, diverging from June forecasts of 6.8 percent, 3.5 percent, and 2.1 percent respectively. The path toward the 2 percent target in the medium term remains central to its forward guidance [citation].
Stagnation drums
Economic activity is showing the combined effects of inflation and higher interest rates. Unemployment in the euro area remains historically low at around 6.6 percent in August, and GDP has continued to grow modestly. Yet leading indicators reveal mixed signals across sectors. The ECB’s July projection called for euro-area growth of 2.8 percent this year and 2.1 percent next year and 1.9 percent in 2024, but the September update nudged these forecasts to 3.1 percent, 0.9 percent, and 1.9 percent respectively. [citation]
In the central scenario, energy supply constraints and other shocks weigh on activity, with risks tilted to the downside. A prudent approach to policy remains essential as the eurozone navigates a challenging energy landscape and the global inflation environment [citation].