ECB increases interest rates to highest level since 2001

The European Central Bank has raised interest rates by a quarter-point to 3.5 per cent and signalled that it will increase them again in July, warning that inflation is far from vanquished.

The ECB’s decision on Thursday to increase its benchmark deposit rate to its highest level in 22 years came as it raised its inflation forecast and trimmed its growth prediction for the next three years.

Christine Lagarde, ECB president, said after the meeting that rate-setters “still have ground to cover” and that they would probably tighten borrowing conditions again at the next policy meeting on July 27 unless there was a “material change” to the economic data.

The bank repeated its warning that it expected inflation “to remain too high for too long” as it will not return to its 2 per cent target from now until 2025.

“This is a hawkish hike,” said Claus Vistesen, an economist at research group Pantheon Macroeconomics, adding that the ECB’s new forecasts were “decidedly stagflationary”.

The yield on the two-year German government bond rose slightly to 3.18 per cent after the announcement, but fell back later in the afternoon. The euro was up 0.1 per cent against the dollar, to $1.08.

The central bank’s latest rate rise contrasts with the US Federal Reserve’s decision to pause rate increases a day before.

The ECB started raising rates several months after the Fed and, at 6.1 per cent, inflation is now higher in the eurozone than in the US.

Eurozone headline inflation has fallen from a record 10.6 per cent in October. But that mainly reflects lower energy costs and the ECB worries that a long period of high inflation risks a spiral of rising wages and costs that keeps price pressures elevated.

Pay per eurozone employee rose 5.2 per cent in the first quarter compared with a year ago, up from 4.8 per cent in the fourth quarter, according to ECB data published last week. 

The ECB raised its forecast for core inflation to 5.1 per cent this year, 3 per cent next year and 2.3 per cent in 2025 — in part because of the strength of the labour market.

Jörg Asmussen, a former ECB executive who now runs the German insurance association, said he expected rate-setters to remain in tightening mode for some time. “I would not be surprised if markets had to correct their interest rate expectations, especially regarding the time of the first rate cut.”

Equity markets, already lower on the day, remained in negative territory following the central bank’s move. France’s Cac 40 and Germany’s Dax index traded 1 per cent and 0.8 per cent lower, respectively.

Despite low unemployment, the eurozone economy remains weak, shrinking slightly for the past two quarters, although it has proved more resilient than first feared after Russia’s full-scale invasion of Ukraine.

Lagarde said the council had spent a long time discussing the “enigma” of the eurozone labour market, where unemployment has fallen to a record low after 1mn jobs were added in the first quarter of the year.

Productivity has fallen as wages have risen, she said, adding that this was raising prices. Lagarde added that the ECB had yet to see a wage-price spiral, but wanted to avoid a “tit-for-tat” situation where workers demanded higher wages, causing companies to jack up prices to preserve their profit margins.

The ECB slightly lowered its growth projections. It now expects the region’s economy to expand 0.9 per cent this year, 1.5 per cent in 2024 and 1.6 per cent in 2025.

The central bank confirmed that it would stop reinvesting the proceeds of its asset purchase programme from July — a move expected to help shrink its balance sheet by €25bn a month.

Additional reporting by Philip Stafford and George Steer in London