ECB rate-setters worried weak euro would fuel higher inflation

European Central Bank (ECB) rate-setters expressed mounting concern that the weak euro would feed higher inflation when they decided last month to raise interest rates for the first time in more than a decade, minutes published on Thursday from their meeting revealed.

Concerns about soaring inflation, which some feared might not be tamed even if the energy supply crisis intensified, appeared to outweigh worries about a weakening growth outlook during the deliberations of the ECB governing council in July.

Policymakers at the meeting raised the ECB’s deposit rate by a greater than expected half-percentage point to zero and signalled more increases to come.

“Members widely noted that the depreciation of the euro constituted an important change in the external environment and implied greater inflationary pressures for the euro area, in particular through higher costs of energy imports invoiced in US dollars,” said the ECB.

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Some policymakers argued it should stick to its earlier plan for a 25 basis-point rate rise in July, rather than the 50-basis point rise it ultimately decided on.

But most of them agreed their decision to launch a new bond-buying programme to tackle unjustified divergence in borrowing costs between eurozone member states — dubbed the transmission protection instrument — enabled them to take a bolder approach.

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Rate-setters identified a growing number of upside risks to inflation, which hit a record for the eurozone of 8.9 per cent in July. As well as the weaker euro, these included “a durable worsening of the production capacity of the euro area economy, persistently high energy and food prices, inflation expectations rising above [the 2 per cent] target and higher than anticipated wage rises”.

“It was argued that even a recession would not necessarily diminish upside risks, especially if it was related to a gas cut-off or another supply shock implying a further increase in inflation,” the ECB said. However, other council members argued low growth would “itself take care of low inflation”.

Since last month’s meeting economists have raised their forecasts for euro zone inflation over the next two years, reflecting a rise in European wholesale gas and electricity prices to record levels in response to fears of a potential shortfall caused by Russia making further cuts to supplies.

This has prompted investors to bet the ECB will raise rates by a further half percentage point at next month’s meeting in an effort to cool price growth, even though many economists fear the eurozone could fall into recession this winter.

The hawkish mood is likely to be reflected in this week’s meeting of central bankers at Jackson Hole, Wyoming. Federal Reserve chair Jay Powell is on Friday expected to underscore the central bank’s commitment to do what is needed to combat inflation, even if it determines it may soon be appropriate to start implementing smaller rate rises than the third consecutive increase of 0.75 percentage points that some Fed rate-setters have called for next month. — Copyright The Financial Times Limited 2022