The European Central Bank is dealing with record inflation and a slowdown in the economy, with many economists predicting a recession in the region before the end of the year.
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European Central Bank President Christine Lagarde said on Friday that the European Central Bank will continue to raise interest rates and may even need to restrict economic activity to tame inflation, naming rates as the bank’s main tool for reducing the balance sheet.
The European Central Bank raised interest rates by an unprecedented 200 basis points since July to tackle inflation, and said further policy tightening comes through higher interest rates and cuts on its 5 trillion euros ($5.2 trillion) of debt.
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“We expect interest rates to rise further – and it may not be enough to withdraw facilities,” Lagarde said in a speech at a conference.
“Interest rates are and will remain the main tool for adjusting our policy stance,” she said. “Recognizing that interest rates remain the most effective tool for shaping our policy stance, it is appropriate that the balance sheet be normalized in a measured and predictable manner.”
At 1.5%, the ECB’s deposit rate is not far from the so-called neutral rate, where the bank neither stimulates nor curbs growth. Most estimates of the neutral rate range between 1.5% and 2%, which indicates that after the expected rally in December, the “adjustment” will be removed.
The problem is that inflation, at 10.6%, is well above the ECB’s 2% target, and even a recession, which is now almost certain during the winter months, is unlikely to ease price pressures enough to allow the ECB to let go of the brakes. .
Investors are now split between pricing a 50- and 75-bp increase in December after consecutive 75-bp moves, and see bond holdings decline, also known as quantitative tightening, starting in the first half of 2023.
The ECB will outline plans to reduce the balance sheet in December and the process is expected to begin with the bank being allowed to expire on some, but not all, bonds.
“The ECB will ensure that a phase of high inflation does not fuel inflation expectations, allowing for very high inflation,” Lagarde said.