The European Central Bank was one of the last major central bank holding off on interest rate increases—until this week.
On Thursday, the ECB raised rates by 0.50 percentage points, marking its first hike in 11 years. The size of the hike was a surprise: Economists had expected the central bank to raise rates by just 0.25 percentage points.
The hike still puts the ECB far behind the US Federal Reserve, which has upped rates by 1.5 percentage points since the beginning of the year and could raise them by another 0.75 percentage points later in July. But Lagarde and her colleagues have good reasons to move more slowly. Europe’s economy is in a fragile state as it absorbs the shocks from Russia’s invasion of Ukraine. It was already in the midst of an energy crisis before the recent crippling heat wave put a further crimp on supplies.
There’s also growing concern that Russian president Vladimir Putin will stop sending natural gas to Europe altogether, though those fears were somewhat allayed after Russia restored the flow from a key pipeline on Thursday. The International Monetary Fund has warned this would send several EU states into recessions, with Hungary, Slovakia, and the Czech Republic being hit the hardest. Meanwhile, drought risks are contributing to already high food prices.
Inflation in the EU vs. the US
EU inflation topped 2% in mid-2021 as it did in the US, but trailed behind US levels until recently. Consumer prices jumped by 8.6% in June from last year.
The ECB is now also dealing with the euro’s falling value against the US dollar. Because the dollar is the preferred currency for global trade, this will increase European import prices for goods at the same time that gas prices are spiking, Greg Fuzesi, a euro area economist for JPMorgan Chase, pointed out in a research note.
The ECB also has farther to go than the Fed to make borrowing more expensive because its target rate is lower than what the Fed’s was when it started tightening. Given the European economy’s mounting challenges, the central bank may have to pick up the pace of its hikes even more in coming months.