The European Central Bank (ECB) faced its seventh interest-rate increase since last July, marking the first rise in 11 years. In March, the ECB lifted rates by 0.5 points. Despite the financial turmoil that started in the United States and reached Credit Suisse in Europe, the official rate stood at 3.5 percent, the highest since November 2008. Analysts anticipate another increase of 0.25 points in May and possibly further moves later, potentially taking the rate to around 4 percent before it is held steady and then possibly reduced toward the end of this year or early next year, according to most forecasts. ECB chief Christine Lagarde acknowledged in April that there was still room to raise rates, signaling more tightening. On the same Wednesday, the US Federal Reserve raised rates by 0.25 points, bringing the range to 5.0–5.25 percent and leaving open the possibility of a pause in future hikes. It is important to note that these actions are part of a broader effort to curb inflation and stabilize prices across the euro area. This cross-border dynamic is a reminder that monetary policy decisions in major economies can influence financial conditions around the world. Citation: ECB disclosures and market analysis.
2. Why is the ECB moving?
The ECB’s core mission is price stability with a medium-term target near two percent for the euro area. Yet current inflation remains well above that goal. While headline inflation eased to around seven percent in April, core inflation, which excludes energy and unprocessed food, stayed stubbornly high at roughly 5.6 percent. In March the central bank slightly lowered its inflation forecast for this year but increased the projected base rate, excluding energy and food, from 4.2 percent to 4.6 percent. Projections suggest headline inflation at 2.9 percent in 2024 and 2.1 percent in 2025, with core inflation at 2.5 percent and 2.2 percent in those years. The expected path keeps monetary policy tighter than the two-percent target through the projection horizon, guiding policy toward a higher cost of money for a time. This trajectory underscores the ECB’s aim to dampen demand and bring inflation down toward target levels. Citations: ECB projections and inflation data.
3. Why does raising interest rates serve to fight inflation?
Raising rates makes financing more expensive, cooling price pressures as households, firms, and governments adjust their spending and investment plans. In March, lending to euro-area companies declined year over year by about 1.2 percent, with household credit down roughly 0.5 percent. In particular, new mortgage lending fell about 1.5 percent. The goal of such tightening is to reduce overall demand and slow inflation. Banks are also tightening lending standards, and demand for financing has cooled toward levels seen during the 2008 financial crisis and the euro crisis of 2011. This assessment comes from the ECB’s survey of euro-area bank lending in the first quarter of 2023 and related analyses. It reflects a pattern of reduced credit activity as monetary conditions tighten. Citations: ECB loan survey results.
If the intention is to curb loan and mortgage demand as a step toward cooling inflation, the data suggests progress in that direction. As financing becomes more restrained, demand recedes, which helps Pressure on prices ease over time. Market observers continue to monitor the trajectory of lending and pricing signals as the ECB weighs future moves. Citations: loan demand trends and banking sector assessments.
4. Why are new rate hikes expected?
Like many other central banks, the ECB began its tightening cycle after inflation picked up following the pandemic and the energy-price shock linked to the crisis in Ukraine. The institution has moved more gradually than some peers because it started from a lower level of policy rates. Nonetheless, the pace has accelerated to compensate for lost ground. In recent meetings, some policymakers urged restraint, while others favored a quicker path to restore price stability. The current outlook points to another rate increase for the coming meeting in May, but June, July, and beyond remain subjects of debate as the inflation picture evolves and financial conditions shift. Citations: ECB policymaker discussions and recent policy communications.
The ongoing debate captures a balance between a flexible interpretation of the mandate by some officials and a strict focus on price stability by others. The banking sector turbulence further complicates the decision, and future moves will hinge on incoming inflation data, growth signals, and financial stability considerations. Citations: ECB policy debates.
5. What effect could it have on the economy?
Even with low unemployment and a modest growth read in the euro area, the ECB remains mindful of weak growth prospects. The central bank raised its 2024 growth forecast, but trimmed the 2024 and 2025 projections. The higher the rate, the greater the risk of a further slowdown. A tighter monetary stance can weigh on investment and consumption, potentially cooling economic activity in the near term while aiming to reduce inflation over the medium term. Citations: ECB growth projections and economic analyses.
6. And for households?
Higher policy rates translate into more expensive financing for households and businesses, influencing expenditures and planned investments. The official rate serves as a benchmark for other interest rates, including variable-rate mortgages. Euribor, the reference for many mortgages, began rising toward the end of 2021, moving from record lows to higher levels. In April 2023, the average Euribor rate climbed, indicating rising mortgage payments, with expectations of continued increases in the near term. The impact on new loans is similar, as the cost of credit for households slowly firms up, especially if policy rates continue higher. Citations: Euribor trends and mortgage pricing analyses.
New loan pricing also reflects higher costs, with mortgage and consumer loan rates trending upward over the past year. If the ECB maintains or further raises rates, household finances are likely to feel the effect, especially if the rate hike proves not to be the last surprise. Citations: household credit cost trends.
6. And for companies and States?
Financing for companies has grown more expensive as the policy rate rises. The average rate on new loans to businesses increased from around 1.35 percent in February 2022 for mid-sized loans to roughly 3.9 percent in the same month this year. The higher policy rate, along with reduced demand for borrowing, has made securities more costly for both corporate and sovereign borrowers. In the secondary market, yields on long-term government bonds, such as 10-year Spanish bonds, have risen significantly, reflecting higher borrowing costs for governments and investors. As with households, the cost of funding for firms and governments tends to increase with higher ECB rates. Citations: lending-rate and bond-yield trends.