FRANKFURT — The European Central Bank left interest rates unchanged and said it will be phasing out euro-zone bond purchases in bulk for most of the year, in contrast to other major central banks like the Federal Reserve, which are fast moving to phase out easy money to leave in the midst of an inflationary spurt.
Annual inflation in the euro zone rose to a record 5.1% in January, more than double the ECB’s target, putting pressure on the central bank to continue its plans to leave interest rates unchanged for the year to give up.
The ECB’s caution reflects the weaker economic recovery in Europe and the expectation that the current surge in inflation is unlikely to continue as it has not yet spilled over into wages. The ECB is also keeping a close eye on southern Europe, where borrowing costs are rising as investors price in a series of Fed rate hikes, putting pressure on the region’s heavily indebted governments.
“From an economic point of view, the ECB can afford to see through this [higher inflation]. But in terms of a broader message, the optics don’t look great. It looks like the fire brigade is sitting on their hands,” said Stefan Gerlach, a former deputy governor of the Central Bank of Ireland.
The ECB said in a statement it would keep interest rates at minus 0.5% and buy tens of billions of euro-zone bonds monthly until at least October.
ECB officials have repeatedly stressed they are unlikely to do so, but investors disagree, pricing in rate hikes of around 0.3 percentage point through December. This reflects expectations that eurozone inflation will remain well above the ECB’s 2% target this year.
The ECB is increasingly becoming an outlier among global central banks as both advanced and emerging economies begin or will soon increase the cost of borrowing.
The Bank of England said earlier on Thursday it would raise interest rates to 0.5% for the second straight meeting and begin to reduce its bond holdings. Fed Chairman Jerome Powell signaled last week that the US Federal Reserve would start raising interest rates as early as March. Investors are expecting about five rate hikes from the Fed this year alone and a reduction in their bond holdings.
In the Eurozone, inflation is still slightly lower than in the US and UK, but its steady rise probably surprised the ECB. Eurozone annual inflation of 5.1% in January compares to 5.4% in the UK and 7% in the US in December.
The policy divergence between the Fed and the ECB reflects the US government’s much more aggressive spending and uncertainty about how tighter monetary policy would pan out in southern Europe, which could lead to a major downturn. Crucially, wage growth is sluggish in the eurozone but very strong in the US
The risk is that the ECB will have to raise interest rates sharply to contain inflation, which could smash through the region’s economy and potentially trigger a recession.
In Brazil, the central bank hiked interest rates by 1.5 percentage points to 10.75% on Wednesday and announced another hike at its next meeting. The Bank of Canada signaled last week that it would soon begin raising interest rates from record lows. Australia’s central bank ended its A$350 billion asset purchase program this week.
Bank of Japan Deputy Governor Masazumi Wakatabe on Thursday denied speculation about an early tightening of monetary policy and said the country’s economy was just beginning to recover from the Covid-19 pandemic.
The comment came as some market participants and economists expect the Bank of Japan to follow in the footsteps of the Federal Reserve. In its latest forecast report, the central bank’s policy board expects consumer prices to rise by around 1% by the end of March 2024.
In Europe, economic growth slowed sharply late last year and the recent surge in inflation largely reflects higher energy costs, analysts said. Unlike the US, where wages are skyrocketing, negotiated wages in the euro zone rose 1.36% year-on-year in the third quarter, a record low since the euro was launched in 1999, according to ECB data Tensions have risen in Ukraine, which could further push up European energy costs. The continent also faces a period of political uncertainty with elections in France and Italy over the next 16 months.
In particular, the measures taken by the Fed are likely to spill over into Europe. US interest rate hikes tend to boost the dollar’s value against the euro, which supports European exports, growth and inflation. On the other hand, Fed rate hikes also tend to push up eurozone borrowing costs as capital flows into US markets while US household and corporate spending slows. This tends to dampen European exports and growth.
“For the ECB, the main concern will be upward pressure on European bond yields, which will have a contractionary effect,” Mr Gerlach said. “That will delay any signal from the ECB.”
Italian 10-year government bond yields have risen to 1.45%, the highest since mid-2020. Italy’s public debt amounted to about 155% of the country’s gross domestic product in the three months to September.
In Germany, Europe’s largest economy, price inflation has been hovering around 5% for months, raising concerns about an erosion of purchasing power in an inflation-shy population. Property prices are also rising sharply, up about 12% year-on-year in the third quarter of 2021, partly due to ultra-low interest rates.
“The patience of [ECB’s] The hawks are likely to weaken as underlying inflationary pressures continue to build in the coming months,” said Frederik Ducrozet, economist at Pictet Wealth Management in Geneva.
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