European Central Bank is in a critical phase in the inflation fight with possible rate hikes

The European Central Bank is set to embark on a critical chapter in its inflation fight, likely to usher in more divisive monetary policy moves.

Interest rate hikes to be coupled with a lever for tightening

Beginning this month, when balance-sheet reduction comes into focus, interest-rate hikes will be coupled with an additional lever for compression, making a potential recession more difficult.

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That conceptual complexity would make it difficult to replicate the relative agreement behind this year’s extreme measures in 2023 since every raise necessitates more precise assessments of the economic damage and financial requirements.

Credit Suisse economist Veronika Roharova said,

December will be a tough one, and not knowing when inflation will peak and how quickly it’ll come down, it’s unlikely to get any easier after that. We’re going to see more tension within the ECB as rates approach neutral — if only because we haven’t had much in the recent past.

Irrespective of the choice made by officials under the direction of President Christine Lagarde over hiking interest rates on December 15, it would raise them to the point that is generally considered to no longer support growth.

Hikes to manage inflation shifting from neutral levels

As subsequent rises to manage inflation shift from neutral levels to constraining the economy throughout a depression, that will usher in a new era in ECB’s policy. Finally, there’s the issue of how much borrowing costs should finally increase.

Rates will continue to be the most crucial instrument. Still, the ECB will decide how to begin unravelling trillions of euros‘ worth of treasury securities, or so-called “quantitative tightening.”

The architecture of that policy could ultimately reflect a pragmatic choice that also takes into account the magnitude of the rate increase in December and the speed of subsequent hikes. But unfortunately, there is little information available for authorities to utilize when they attempt to assess the effect of balance-sheet contraction on capital markets, except referring to the Fed’s experience.

The economic situation will be murky, and it needs to be clarified when businesses and consumers will eventually feel the effects of previous rate increases.