A very large majority of members of the European Central Bank (ECB) Governing Council supported the three-quarters of a percentage point interest rate hike agreed at the October meeting, even though it also foresees a technical downturn in the economy.
The minutes of this meeting, released on Thursday, also show that “a few members expressed a preference for increasing ECB interest rates by 50 basis points”.
The ECB raised its interest rate by 75 basis points to 2 % at the meeting on 26-27 October.
AGREEMENT ON RAISING, DIFFERENCES ON THE AMOUNT
The Governing Council was in full agreement on the need to raise interest rates further, the differences centred on the size of the increase.
“An increase in ECB interest rates by 75 basis points was supported by a very large majority of members” of the council, the minutes of the meeting state.
They considered this increase to be appropriate “in view of the prolonged period of excessively high inflation” and that monetary policy was still expansionary.
Therefore, in their view, the 75 basis point increase was a “necessary step towards a more neutral level” and to prevent inflation from remaining elevated for too long.
The few members who were in favour of raising interest rates by 50 basis points argued that prudence in the pace of tightening was necessary.
“An increase of 50 basis points was considered sufficient to tighten monetary policy in a gradual and measured manner, given that market confidence is fragile, the risk of a significant slowdown in economic activity was increasing, and financial conditions had already tightened significantly,” the document adds.
The Governing Council agreed on the need to raise interest rates further at other meetings in the light of economic data.
The Governing Council expects a technical recession in the euro area, i.e. two consecutive quarters of economic contraction.
For the time being, “the clear evidence is more consistent with a mild recession” rather than a hard landing or a prolonged downturn.
All components of demand – consumption, investment and exports – show signs of weakening, according to the ECB.
But this mild recession could turn into a severe and prolonged recession in some countries because of weakening housing markets.
TENSIONS IN REPO MARKETS
The Governing Council agreed that there was a need to change the conditions of the three-year liquidity operations and to give banks more dates to repay the money early.
The ECB, which started raising its interest rates in July, wants banks to pay back their loans very cheaply and has worsened the conditions of the operations to do so.
“The proposed recalibration was appropriate. First, it would contribute to the normalisation of bank funding costs”, to higher inflation over the medium term and to a reduction in the balance sheet, the ECB believes.
In addition, the ECB expects that early repayments will make available some bonds that are now used as collateral and thus alleviate the current collateral shortage and improve banks’ intermediation capacity.
In this way, ECB rate hikes will be more efficiently passed through to secured money market rates.
The shortage of some bonds has created tensions in the repo markets, which are repurchase transactions in which a bank sells government bonds to an investor with a commitment to buy them back at a certain date at a certain price.
In particular, there is a shortage of bonds from Germany and other central and northern European countries and this is keeping yields down, even as the ECB raises interest rates.
The Governing Council noted in October that the September interest rate hike “has not been easily transmitted to all segments of the repo markets”, according to the minutes of the meeting.
Since December 2016, central banks in euro countries have been able to accept cash as collateral when lending out purchased government debt.
The use of this facility to lend bonds against cash has reached its second all-time high since September, according to the ECB.