ECB "Halfway Through Tightening Cycle"... Next Year's Interest Rate Shock

ECB Member Signals Sharp Rate Hike Next Year
"Recession Expected but Will Be Mild"

[Asia Economy Reporter Yujin Cho] The European Central Bank (ECB) is expected to continue raising its key interest rates at the current pace at least until the second quarter of next year. Although the war in Ukraine poses a significant negative factor for the Eurozone (19 countries using the euro), and a recession is expected next year, the depth of the downturn is anticipated to be shallow.

On the 26th (local time), Klaas Knot, ECB policymaker and President of the Dutch Central Bank, said in an interview with major media outlets, "We have only passed the halfway point of the tightening cycle," adding, "It is necessary to maintain higher interest rates for a longer period to tame inflation," hinting at the possibility of sharp rate hikes next year. Knot, who joined the ECB in 1995, is the longest-serving policymaker, having participated in ECB monetary policy meetings since 2011.

In July, the ECB initiated its rate hike campaign by raising the key interest rate for the first time in 11 years with a historic big step (0.5 percentage point increase) since the introduction of the euro in 2002. Subsequently, it implemented giant steps (0.75 percentage point increases) for two consecutive months in September and October this year. At the monetary policy meeting held this month, the ECB, like other central banks such as the U.S. Federal Reserve (Fed) and the Bank of England (BOE), adjusted the rate hike to 0.5 percentage points. This brought the Eurozone’s terminal deposit rate to 2.0%.

The ECB’s decision to narrow the pace of hikes from consecutive high-intensity giant steps to big steps starting in December is seen as a speed adjustment considering the aftereffects of aggressive tightening, rather than signaling the end of the fight against inflation. This means the ECB intends to maintain higher rates for a longer period. Earlier, ECB President Christine Lagarde also forecasted additional tightening, stating that "big steps should be expected for a considerable period." The market currently expects the ECB’s terminal rate to reach 3.75%.

Knot reiterated that the reduction in the rate hike magnitude is not a pivot. He explained, "More than one-third of the members at this month’s monetary policy meeting argued for continuing 0.75 percentage point hikes, but by switching to 0.5 percentage points, we have more time to assess the effects of rate hikes next year."

Class Notes ECB policymaker and President of the Dutch Central Bank (left in photo) and Christine Lagarde, President of the ECB, are moving to attend a press conference after the monetary policy meeting on July 9. [Image source=AFP Yonhap News]

The reason the ECB cannot ease its tightening grip is due to 'high inflation.' Currently, the Eurozone’s inflation rate is five times the ECB’s target. Knot said, "Price pressures will be the ECB’s top concern next year."

The ECB places inflation at the core of its monetary policy stance for next year. The Eurozone’s inflation rate in November was 10.1%, slightly lower than the previous month’s record high of 10.6%. However, unlike U.S. inflation, which stems from wage increase pressures, Eurozone inflation is driven by surging energy and food prices following Russia’s invasion of Ukraine, making it less controllable and more uncertain, thus presenting a worse situation than in the U.S.

Meanwhile, Knot admitted that the ECB was too late in responding to inflation pressures and criticized that the end of bond purchases through the asset purchase program should have been moved forward from March this year to the end of last year.

Economists point out that the ECB is underestimating how quickly inflation will fall next year and how deep the recession will be. The war in Ukraine poses a significant downside risk to the Eurozone economy, with growth expected to sharply decline from 3.4% this year to 0.5% next year. Regarding this, Knot forecasted that although a recession will occur next year, "the recession will be shorter and shallower than we think."

This content was produced with the assistance of AI translation services.