The ECB is dealing with both record-high inflation and a slowing economy, with many economists predicting a recession in the region before the end of the year.
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The European Central Bank will keep raising interest rates and may even need to restrict economic activity to tame inflation, ECB President Christine Lagarde said on Friday, singling out rates as the bank’s key instrument over balance sheet reduction.
The ECB has raised rates by an unprecedented 200 basis points since July to tackle inflation, and said that more policy tightening is coming via rate hikes and the reduction of its 5 trillion euro ($5.2 trillion) debt holding.
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“We expect to raise rates further – and withdrawing accommodation may not be enough,” Lagarde said in a speech at a conference.
“Interest rates are, and will remain, the main tool for adjusting our policy stance,” she said. “Acknowledging that interest rates remain the most effective tool for shaping our policy stance, it is appropriate that the balance sheet is normalised in a measured and predictable way.”
At 1.5%, the ECB’s deposit rate is not far from the so-called neutral rate, where the bank is neither stimulating nor holding back growth. Most estimates of the neutral rate are between 1.5% and 2%, suggesting that after an expected December hike “accommodation” will have been removed.
The problem is that inflation, running at 10.6%, is far above the ECB’s 2% target and even a recession, now almost certain over the winter months, is unlikely to ease price pressures enough to let the ECB step off the brakes.
Investors are now split between pricing a 50 and 75 basis-point hike in December after back-to-back 75 basis point moves, and see the reduction of bond holdings, also known as quantitative tightening, starting in the first half of 2023.
The ECB will outline plans for balance sheet reduction in December and the process is expected to start with the bank allowing some, but not all, bonds to expire.
“The ECB will ensure that a phase of high inflation does not feed into inflation expectations, allowing too-high inflation to become entrenched,” Lagarde said.
Read More: ECB may have to restrict growth to control inflation, Lagarde says