ECB makes amends for forecasting errors with jumbo rate hike

The European Central Bank has had its head in the sand on inflation. From the get-go last year, it played down the crisis, insisting it was a temporary post-Covid phenomenon, low-balling even the most benign forecasts for price growth.

ECB chief Christine Lagarde and the bank’s chief economist Philip Lane were using the word “transitory”, predicting the whole thing would blow over in the second half of 2022, long after everybody else had dumped such an optimistic notion, and right until Russia’s invasion of Ukraine effectively ended the argument.

Frankfurt was the last of its peers to increase interest rates, opting for 0.5 per cent rate hike in July, long after the Fed, the Bank of England and the Bank of Canada had begun a process of monetary tightening

Probably because it is governed by technocrats and economists, it has always been slower to react, less inclined to change course or submit to market pressures, an accusation often levelled at the Federal Reserve in the US. As a result, it has implemented a fraction of the rate changes that the Fed has adopted over the past 20 years.

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[ ECB raises interest rate by three quarters of a percentage point ]

[ Irish banks review non-tracker rates after ECB’s latest hike ]

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Thursday’s 0.75 per cent rate, the biggest in the ECB’s history, is a de facto admission of its slow reaction time to date and a win for the financial hawks within the bank’s governing council, who have been pushing for tougher action for months. That’s not to say that raising interest rates in the face of surging energy prices driven by a war in Europe is an effective tool but it’s an admission that core inflation is at risk of becoming embedded in the system.

While the three-quarter point rate hike had been expected or at least priced in by markets, the bank’s signalling of further rate hikes (the ECB’s statement was explicit about more rate hikes being needed) and its revised macroeconomic forecasts were perhaps more significant.

The central bank now sees euro zone inflation averaging 8.1 per cent this year against a 6.8 per cent prediction in June, while the 2023 price growth estimate is now 5.5 per cent, up from 3.5 per cent.

The impact of high energy prices also saw the bank slash its 2023 growth forecast to just 0.9 per cent down from 2.1 per cent. That doesn’t preclude a period of negative growth, in other words a recession, in the interim.

ECB president Christine Lagarde staunchly defended her staff’s economic forecasting on Thursday, pointing out that major factors such as the pandemic and Russia’s invasion of Ukraine were all but impossible to forecast.

She said most international institutions and economists also made forecasting errors because “it’s virtually impossible to actually anticipate and include in your models Covid, the war in Ukraine, the energy blackmail”.

“So while I take the blame because I am the head of the institution and yes, we made forecasting errors, but those errors were made by all forecasters. We are not very different from them.”