The European Central Bank has just raised interest rates for the first time in more than a decade, while unveiling its new anti-fragmentation tool.
It comes just in time as Italian political risk returns. Azad Zangana, senior European economist and strategist at Schroders, shares his analysis.
The European Central Bank (ECB) raised interest rates for the first time in 11 years. Although it signaled a 25 basis point (bp) hike at its last Governing Council meeting, the ECB instead opted for a more aggressive 50 bp increase, bringing the deposit rate to zero, the principal refinancing rate at 0.50% and the marginal lending facility rate. at 0.75%. The move is historically significant as it also ends the era of negative interest rates, which controversially began in the summer of 2014.
The ECB said the larger hike was warranted as inflation developments had become more concerning, including the depreciation of the euro. Inflation reached a new high for the monetary union, reaching 8.6% year-on-year in June. The ECB also mentioned that while economic indicators suggested slowing growth, the labor market remained very robust with unemployment at historically low levels. This increases the risk that wages will rise in response to higher inflation, which could then further increase price pressures. A slowdown in demand is therefore justified.
The direction of the rates is fixed, but the end point is still unknown
Investors were a bit surprised by the magnitude of the rate hike. Consensus forecasts had expected a 25 basis point hike, but money markets had forecast a 40 basis point hike, suggesting a 60% chance of an eventual 50 basis point hike. Interestingly, despite the more hawkish move, the euro retreated from the initial rally against most other currencies, while government bond yields also fell, raising concerns.
This may be because the ECB effectively rescinded its previous promise to raise interest rates by 50 basis points at its September meeting if inflation conditions did not improve. The change in language does not rule out another similar or even larger rate hike, but it does increase the risk that by September interest rates could end up exactly where they were supposed to reach before.
The more dovish guidance for September may have been part of the compromise within the board of governors to push for a bigger and more immediate increase. The ECB says it will depend on data from meeting to meeting, which should mean several bigger rate hikes ahead. The bank’s statement also suggests that today’s decision does not affect the final level at which interest rates will settle, although ECB President Christine Lagarde admitted that the committee did not know where the final level, or “terminal rate”, would be. Only that interest rates should rise further.
What about the anti-fragmentation tool?
One of the constraints to raising interest rates that the ECB is now happy to discuss openly was the impact on weaker member states often referred to as the periphery. Italy in particular has been thrust into the spotlight, with investors demanding a lower price (higher yield) to offset riskier fundamentals, especially after the ECB ended its biased support through of its QE programs.
At its last official meeting, the ECB announced that it plans to use maturing assets from the Pandemic Emergency Purchase Program (PEPP) to prevent spreads from widening further. That was not enough at the time to stop bond vigilantes from driving Italian yields higher. The ECB then returned with an emergency meeting on June 15 to promise a new anti-fragmentation tool that would work on top of reusing PEPP assets.
The ECB unveiled its new tool called Transmission Protection Instrument (TPI), which would be used effectively to prevent bond spreads from widening too much.
What matters to investors is that there are no limits on the use of this tool at this time, but again there is no size commitment for the fund. It is clear from the market reaction that investors were not impressed. The spread between Italian and German 10-year government bond yields widened after the announcement. It is clear that the ECB hopes that the TPI will resemble the Outright Monetary Transactions (OMT) programme. A tool that was unveiled by former ECB President Mario Draghi in 2012 to help peripheral governments, which eventually succeeded without ever being used.
What’s going on in Rome?
Draghi’s role in helping Italy’s debt crisis may have begun more than a decade ago, but it appears to be coming to an end. Investors were very focused on the ECB’s response as the political situation in Italy deteriorated significantly.
Italian Prime Minister Draghi has tendered his resignation for the second time in a week, after initially losing support from the coalition government’s Five Star Movement. Then he resigned again after failing to secure a vote of confidence in parliament, which had been requested by President Sergio Mattarella.
It is now very likely that Mattarella will accept Draghi’s (second) resignation and offer to dissolve parliament to allow new elections in September or October. An election was to be held in the spring of next year. The downside of the previous election is that it is likely to reduce the time the government has to produce a budget this fall, and so significant tax and spending changes are now unlikely. This could jeopardize Italy’s attempt to satisfy the European Commission in order to release the next tranche of funding for the NextGenEU programme.
The latest opinion polls put the Brothers of Italy party (Fratelli d’Italia, or Fdl) in the lead, making party leader Giorgia Meloni the favorite to become the next (and first female) prime minister. However, the right-wing nationalist party will surely clash with the European Union, which will worry investors.
The Fdl have in the past called for a renegotiation of the eurozone and EU treaties, which may not be as extreme as, for example, the “Italexit” party (self-explanatory ).
The ECB should continue to raise interest rates at a sustained and accelerated pace to reduce the risk of inflation becoming entrenched. Schroders forecasts that the main refinance interest rate will hit 1% by the end of this year, but it now looks like a target of 1.5% might be more appropriate.
The political upheaval in Italy will reintroduce market volatility and will certainly test the ECB’s resolve as to when, rather than if, it will step in to bail out Italy once again.