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As expected, the ECB raised its key interest rate by 0.75 percentage points on Thursday, bringing it to its highest level since 2009. This brings it closer to the level considered to have a “neutral” impact on the economy, which market participants estimate at around 2% by December.

Thanks to the ECB’s cheap loan program, financial institutions have been able to make risk-free profits by parking cash at a higher rate. Now, the central bank has brought the two interest rates more in line, reducing the banks’ profits in the process.

The ECB’s silence on quantitative tightening leaves us in the dark about how it plans to shrink its balance sheet. We’ll just have to wait a bit longer to find out. They also avoided giving an update on the likely path of future hikes.
 

What’s Next, Then?

The combination of low growth and high inflation is becoming increasingly dangerous. Like most other regions, Europe is caught between a rock and a hard place: it is facing an economic recession, but stubbornly high inflation is preventing governments and central banks from implementing pro-growth policies. 

The more the ECB is forced to raise interest rates in the midst of a recession, the deeper the recession is likely to be. But if it doesn’t raise rates, or if it is perceived as holding back on rate hikes, it risks more inflationary pressure. In other words: as long as inflation remains high, there is no easy solution.

As tensions rise among European politicians, the risk of further fracturing the already fragile unity of the Eurozone increases. Recently, Italy’s Prime Minister Giorgia Meloni and France’s President Emmanuel Macron have openly criticized the European Central Bank’s aggressive rate hikes, putting additional pressure on the ECB’s upcoming decisions. This mounting political pressure creates a greater risk of eurozone disintegration.

The risk of a financial accident is increasing. With the economy slowing down, liquidity drying up, and a scarcity of high-quality collateral, the chances of a “UK-style” financial accident are rising rapidly.

The ECB is no longer saying that it plans to raise interest rates at every meeting but instead is emphasizing the importance of data. This is likely to be interpreted as a dovish shift from market participants.

Today, the market might interpret the ECB’s less aggressive tone as a positive development for EU assets. However, it’s important to remember that political, financial, and macroeconomic risks are still rising. Now more than ever, everything depends on what happens next with inflation.

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