ECB Raises Rates Again: Reasons and Consequences for the Eurozone

On July 27, 2023 the European Central Bank (ECB) made a decision to raise its key interest rate by 0.25%. The ECB increased its key interest rates for the nine time in a row, reaching the highest levels seen since 2008. However, this time, the rate hike was more moderate, with a 25 basis points increase. At the same time, the Federal Reserve of the United States (FRS) also raised its benchmark interest rate for the twelfth consecutive time, reaching the highest level since 2007.

Let’s figure out why this decision was taken and what its potential consequences might be.

How the ECB Rate Works and What it Affects?

The ECB sets its key interest rate, which is the main rate for the Eurozone, similar to the key interest rate of the Central Bank in Russia. This rate determines the cost of borrowing for banks in the Eurozone. When the rate is increased, it makes loans more expensive for banks, which can lead to an increase in the cost of all loans provided by banks to consumers and businesses in the Eurozone.

There are three other important rates set by the ECB:

1. The rate on main refinancing operations: This is the rate at which the ECB provides loans to banks for one week. It is the primary rate that influences the overall monetary policy.

2. The marginal lending rate: This is the rate at which the ECB provides short-term loans to banks, usually for one day. It helps banks to maintain their daily operations and liquidity.

3. The deposit rate: This is the rate that banks receive for depositing their money with the ECB. When this rate is high, banks are less interested in keeping money with the ECB and prefer to use it actively by providing loans to customers.

The three rates of the European Central Bank (ECB) are like different tools used in a recording studio to control the economy. They can be adjusted together or independently, depending on the economic situation.

For example, between 2016 and 2019, the ECB kept the rates for marginal lending and refinancing unchanged at 0.25% and 0%, respectively, but reduced the deposit rate from -0.4% to -0.5%.

These rates play a crucial role in the ECB’s efforts to regulate the Eurozone’s economy. When inflation becomes too high, and prices are rising rapidly, the ECB increases its main interest rate to discourage excessive spending and curb inflation.

Conversely, if consumption is low, and prices are not rising or even declining due to reduced spending, the ECB lowers the rates to encourage borrowing and spending, thereby stimulating economic activity.

When the European Central Bank (ECB) interest rate is high, loans become more expensive, and deposit rates increase. This makes deposits more attractive to investors, and they may move their money to countries with higher interest rates. 

As a result, the value of money in the country where the ECB raised the rate may decrease. Alternatively, when the ECB rate is lowered, deposit rates become less appealing to investors, and they may seek more profitable options in other countries with higher interest rates. This can lead to a decrease in the currency value in the country where the ECB reduced the rate.

The EU Economy’s Situation 

Since July 2022, monetary authorities have been implementing an unprecedented series of interest rate hikes after several years of keeping rates near zero or in negative territory. The reason for these rate hikes is the high inflation rate that the economy has been experiencing. The European Central Bank (ECB) has been steadily raising its key interest rates, increasing them by a total of four percentage points since the summer of 2022. This pace of increase is faster and more substantial than any previous rate adjustments in the ECB’s history.

The uncertain outlook for monetary policy is primarily a result of economic instability. Although inflation has decreased significantly in recent months, the core inflation remains high, indicating that the underlying price pressures are still strong. In addition, there is a noticeable slowdown in economic growth, particularly in the industrial sector, as indicated by gloomy indicators from S&P Global.

Germany’s economy is facing particular challenges as it is growing at a much slower pace compared to other major economies in the eurozone. In fact, Germany’s real gross domestic product (GDP) is projected to contract by 0.3% this year, while other countries like the United States, Russia, and China are expected to experience positive growth.

Germany’s economic difficulties are further compounded by the loss of a major supplier of cheap energy and a significant portion of the Russian market. Moreover, the European Union is also grappling with the relocation of manufacturing to the United States, as more companies choose to move their production facilities. Additionally, strained relations with China, an essential trading partner for Europe, are adding pressure on the situation. The uncertainty in the economic landscape and the challenges posed by global events are shaping the current economic conditions in the region.

What Will be The Consequences?

As the European Central Bank (ECB) raises its interest rates, several consequences are expected:

Inflation in the Eurozone is projected to decrease. The ECB hopes that the rate hike will result in inflation decreasing to 3.5% in 2023, and eventually stabilizing at 2.1% by 2024.

The threat of recession becomes more real. The rate hike corresponds to an economic slowdown. The ECB has already lowered economic growth forecasts for Eurozone countries, expecting a decline from 2.8% to 2.1% in 2023. Prior to the rate increase, concerns about a recession were widely discussed, and it’s worth mentioning that the higher borrowing costs resulting from the interest rate hike could indeed trigger a recession.

Indebted countries face the risk of default. As interest rates on deposits increase, demand for government bonds with low yields diminishes. This leads to higher borrowing costs as investors expect higher returns than current rates. This poses a challenge for heavily-indebted countries like Italy, whose debt-to-GDP ratio is 150%, and raises the risk of default. 

To prevent defaults, the ECB plans to use a Transmission Protection Instrument (TPI), which involves purchasing government bonds with maturities ranging from one to ten years for countries whose bond prices experience excessive volatility “not due to purely domestic factors,” i.e., speculative collapse in their value. This measure aims to create demand for these bonds in the market, restraining the rise in borrowing costs for troubled countries and reducing the risk of default.

Additionally, the ECB may consider purchasing corporate bonds, which would make sense as large holdings in some countries play a significant role in their economies, such as Mercedes in Germany. However, no specific details about the TPI have been revealed yet.

The growth pace of European companies will slow down. The rate hike indicates a decrease in inflation, consumption, and investments. As a result, production of goods and consumption of services will decelerate alongside inflation. European goods abroad will become more expensive due to the stronger Euro, leading to reduced export revenues. This will have a noticeable impact since many European companies, like BASF, Hapag-Lloyd, and others, rely on revenues generated outside the Eurozone.

Moreover, the attractiveness of European company stocks to investors will decrease. The rise in deposit rates might cause some people, who are not willing to tolerate volatility but still want their money to grow, to withdraw from the stock market.
The Euro’s exchange rate will rise. On such news, the Euro’s value is expected to increase. However, it’s important to consider that if the US also raises interest rates, the Dollar will appreciate, potentially offsetting the difference.