March 16, 2023—The European Central Bank raised its three key interest rates by 50 basis points in response to persistently high inflation. That increases the main refinancing operations, the marginal lending facilities, and the deposit facility to 3.5 percent, 3.75 percent, and 3 percent, respectively. Those rates are up from 0.00 percent, 0.25 percent, and -0.50 percent in June 2022.
The move comes in the middle market turmoil stemming from pressure in the banking system over recent rate rises.
In its press release, the ECB noted an “elevated level of uncertainty.” It takes place as financial distress hits the banking sector in the United States and in Europe. Two U.S. banks collapsed in less than a week, posing a ripple effect of instability for the entire sector. Meanwhile, Swiss-based Credit Suisse faced similar trouble until the Swiss National Bank provided a loan guarantee on Wednesday.
Lag Effect
It’s noteworthy that moves on key interest rates by central banks have a lag effect. While decisions by the Federal Reserve and the ECB can have an immediate impact on financial markets, it can take up to 18 months for them to change economies.
Making matters more uncertain, governing boards in the United States and Europe are often reluctant to change the course of plans they have previously announced. For example, both the ECB and the Federal Reserve reacted late to rising inflation, holding their rates at and below zero well past signs of trouble. Today, the central banks might be making the same mistake in holding to their plans despite signs of turmoil.
European and U.S. central banks typically coordinate policies. The U.S. Federal Reserve is scheduled to meet March 21-22. It’ll be the first policy decision since the recent banking failures of Signature Bank and Silicon Valley Bank.
Other Credit Tools
The ECB Governing Council said it has other tools to provide liquidity—access to cash.
“The euro area banking sector is resilient, with strong capital and liquidity positions,” the ECB press release said. “In any case, the ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy.”
The ECB staff projects Euro-area headline inflation averaging 5.3 percent in 2023 and heading down to 2.9 percent in 2024. Meanwhile, they projected economic growth to increase to 1 percent in 2023.
Impact Of Higher Borrowing Costs
The higher rates put the most pressure on countries carrying a lot of debt on their books. That means indebted countries like Italy, Greece, and Spain face higher borrowing costs. So far, private investors have been continuing to buy bonds. Furthermore, the EU pandemic recovery funds have poured into those countries to help carry the weight.
It’s unclear how the higher borrowing costs will ultimately impact consumers. What is clear is that the economic landscape will continue to rumble. Asked about the risk of a financial crisis, ECB President Christine Lagarde said the governing board will handle that separately.
“We don’t see any tradeoff between price stability and financial stability, and we will address each of these two with their respective instrument,” Lagarde said.
That means the ECB will continue to raise interest rates to fight inflation. It will employ other tools, such as loan and liquidity support for banks, separately.
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