Last Thursday marked the tenth hike of the European Central Bank (“ECB”) deposit rate.
This hike was particularly significant due to a combination of factors:
- Since the inception of the Euro in 1999, the ECB deposit rate has never hit 4 percent.
- Until last week the all-time peak for ECB rates was 3.75 percent over a 3-month period from December 2000 to March 2001.
To contextualize this, the last time ECB rates were remotely close to current levels, the Euro had been in circulation for less than a year. Additionally, the economic reasoning behind these elevated rates was quite different than what we are currently witnessing.
The largest differences stem from the economic picture in the Eurozone today versus the past. When rates were last at 3.75 percent in 2000, the European Union was in a period of robust economic growth. While the Euro was beginning to gain adoption, higher rates were used as a tactic to attract new capital and gain adoption, with the main goal of expanding the Eurozone. During this time, the Eurozone economy was also booming with year-over-year GDP growth sitting at approximately 3.2 percent. The newly formed ECB instituted strict monetary policy focused on controlling inflation. As a result, inflation in the Eurozone was relatively low hovering around the target 2 percent. Additionally, prices and the labor market were stable and there was no upward pressure on commodities. At the time, higher rates were a positive indicator, and a show of confidence in the future of the Eurozone and the global economy.
Today, we have quite the opposite situation. The Eurozone is battling low GDP growth, about one fourth of the levels found in late 2000. Much worse is that Eurozone inflation is at 5.2 percent. Throughout 2022, the region experienced immense upward pressure on commodity prices (more than the U.S.) due to the Russia/Ukraine conflict. One will recall spiking natural gas and electricity prices in the latter half of the year – both pressures that have just recently ceased contributing to higher inflation. On the other hand, Eurozone labor/wage markets have had similar dislocations to the U.S. as the unemployment rate is at a multi-decade low.
Unlike in 2000, the intent behind the current rate cycle has been to dial back runaway inflation and tighten the money supply. The two scenarios share little in common. Yet, while all the symptoms are the opposite of what we were experiencing in 2000, why is the ECB facing the same solution? While Europe is not unique in facing low growth and high inflation, it is noteworthy to consider another point at which there was a widespread systemic failure in the global economy. During the Global Financial Crisis, ECB rates peaked at 3.25 percent, followed by a series of cuts ending with the ECB rate at 25 basis points by the first quarter of 2009. The Eurozone is in unchartered territory regarding rate levels, and while some ECB governors have advocated for a pause, President Lagarde has not said this is the peak for interest rates. She has, however, acknowledged the increase in borrowing costs is having the intended impact of tightening financial conditions. As seen in this month’s chart, rates currently sit at 3.9 percent, with investors pricing in hikes through mid-2024.
The economic landscape in Europe implies that the ECB is more distant from their last rate cut than the Fed. Lagarde has acknowledged that it is unclear how long the ECB’s tightening cycle will persist due to the unprecedented situation but is reluctant to provide further details.