European Central Bank walking a tightrope as rate-hiking cycle commences

Delivering on its commitment made at the June meeting, the European Central Bank (ECB) on Thursday increased interest rates by 50 basis points, the first rate hike in 11 years by the bank that is on track to normalize its monetary policies.

With bond-buying programs coming to an end as of July 1 and interest rates lifted, financial conditions in the eurozone will inevitably be tightened and the spread between government bonds issued by some EU member states and those of Germany is expected to be widened.

Since it is extremely difficult, if not impossible, to stave off red-hot inflation and soaring government bond yields at the same time, the ECB needs to tread carefully on a narrow path.

FIRST RATE HIKE SINCE 2011

The interest rate on main refinancing operations, marginal lending and deposit facilities will be increased to 0.5 percent, 0.75 percent and 0 percent respectively, which will take effect on July 27, the ECB said Thursday in a statement following a Governing Council meeting.

It was the first time the ECB raised key interest rates since 2011, a sign that the accommodative monetary policies, marked by ultra-low interest rates and bond-buying operations, have come to an end.

The central bank reaffirmed that it would continue to tighten policies as monetary policy normalization gains traction.

"At the Governing Council's upcoming meetings, further normalization of interest rates will be appropriate," it said.

The rate hike is larger than the ECB's announcement in June at its previous Government Council meeting that a hike of 25 basic points will be due in July.

"The Governing Council judged that it is appropriate to take a larger first step on its policy rate normalization path than signalled at its previous meeting," the bank said in its latest statement.

RED-HOT INFLATION

Some members of the bank's Governing Council have been calling for a larger rate increase as inflation in the eurozone has been running wild, up from 8.1 percent in May to 8.6 percent in June.

Food prices in the eurozone soared further to 8.9 percent in June, stoking anxieties over an entrenched inflation that could significantly undermine consumer demand.

The ECB, which is mandated to keep the inflation rate at around 2 percent in the medium term, said inflation will remain "undesirably high for some time."

German Central Bank President Joachim Nagel said in a speech in early July that a de-anchoring of inflation expectations should be prevented.

"The more tentatively monetary policy acts now, the more it risks getting into a situation where it would need to tighten all the more strongly and abruptly in order to preserve price stability," he said.

RISK OF NEW DEBT CRISIS

The ECB said in the statement that its Governing Council has also approved the Transmission Protection Instrument (TPI), an anti-fragmentation tool to rein in soaring government bond yields of some countries in the eurozone.

For years, the ECB's low interest rates and bond purchases have enabled EU governments to borrow at a low cost. However, as the bank recently tightened its monetary policies to deal with roaring inflation, the yields of government bonds issued by some member states, especially Italy, have begun to surge.

Italy's 10-year bond yield topped 4 percent at one point on June 14, prompting the ECB to convene an emergency meeting on June 15. It is still hovering at around 3.6 percent during the trading on Thursday, partly because of the country's debt that amounts to more than 150 percent of its GDP and of the political turmoil following Mario Draghi's resignation as Italy's prime minister.

In an apparent bid to prevent the bond yields from spiraling out of control, the ECB approved the TPI "to counter unwarranted, disorderly market dynamics."

The bank will mainly buy securities on the second market. "The scale of TPI purchases depends on the severity of the risks facing (monetary) policy transmission. Purchases are not restricted ex ante," said the ECB.