The ECB faces both record 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 continue to raise interest rates and may even have to restrict economic activity to bring inflation under control, ECB President Christine Lagarde said on Friday, pointing to rates as the key instrument of bank in relation to balance sheet reduction.
The ECB raised rates by an unprecedented 200 basis points since July to fight inflation, and said further policy tightening will come via rate hikes and debt reduction by 5 trillion euros ($5.2 trillion).
“We plan to increase rates further — and taking accommodation away 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,” she said. “Recognizing that interest rates remain the most effective tool to shape our policy, the balance sheet should be normalized 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 neither stimulates nor hinders growth. Most estimates of the neutral rate are between 1.5% and 2%, suggesting that after an expected rise in December, the “accommodation” will have been removed.
The problem is that inflation, at 10.6%, is well above the ECB’s 2% target and even a recession, now all but certain over the winter months, is unlikely to ease the pressures enough. on prices to let the ECB lift the brakes.
Investors are now torn between pricing a 50 and 75 basis point hike in December after consecutive 75 basis point moves, and see the reduction in bond holdings, also known as quantitative tightening, from of the first half of 2023.
The ECB will present plans to reduce the balance sheet in December and the process should begin with the bank allowing the expiry of some bonds, but not all.
“The ECB will ensure that a phase of high inflation does not fuel inflation expectations, allowing too high inflation to take hold,” Lagarde said.