The European Central Bank is about to raise interest rates for the first time in 11 years as it attempts to put a lid on record inflation fed by surging energy prices.
What's happening: The ECB has made clear that it will hike rates at its meeting on Thursday for the first time in 4,032 days. The only question is the size of the increase, which could be as high as half a percentage point.
Strategists think the central bank is likely to stick to a smaller increase of a quarter of a percentage point, betting that the ECB will be hesitant to contradict the past guidance it handed markets.
But they also worry that a smaller rate hike could be a mistake. Annual inflation in the European Union jumped to 9.6% in June. It reached 8.6% for the 19 countries that use the euro.
"The risk of a [half point] hike has grown materially and is almost a coin toss," said James Rossiter, head of global macro strategy at TD Securities. "It is the sensible outcome to the meeting, but goes against recent communications."
The challenge facing the ECB isn't just the rate of inflation. It's also that the central bank is pacing far behind its peers. Interest rates are still in negative territory, which critics say is making the run-up in prices even worse.
After cutting rates to zero at the beginning of the pandemic, the Fed has been on a rate-hiking spree since March, raising its benchmark rate in huge increments over the past few months to combat runaway inflation. Only the Bank of Japan — which on Thursday maintained its super-easy policies — hasn't budged.
But the ECB is grappling with an even tougher set of circumstances than other central banks.
🛢 Surging energy prices in Europe, exacerbated by Russia's invasion of Ukraine, are the biggest contributor to rampant inflation. Yet what happens on that front is completely out of the ECB's control.
Russia's Gazprom resumed gas shipments along the crucial Nord Stream 1 pipeline on Thursday, easing fears that it wouldn't come back online after a period of scheduled maintenance.
Anxiety lingers that Russia could shut off gas at some point in the future in retaliation for sanctions, however. European natural gas prices are holding steady and remain near their highest level since March.
🇮🇹 Italy, Europe's third biggest economy, is also in the throes of a political crisis that's rattling the country's stock and bond markets.
Italian Prime Minister Mario Draghi, an investor favorite, submitted his resignation to the president on Thursday after losing the support of several key parties in his governing coalition. That could lead to early elections.
The ECB is expected to unveil a new tool aimed at calming bond markets in more vulnerable countries in the euro zone such as Italy. It will need to pick its words carefully, though, since it wants to be viewed as staying above the political fray.
Looking ahead: Recession risks in Europe are rising sharply. That could constrain the ECB's ability to keep hiking interest rates, which help combat inflation but also slow down the economy. The central bank may have not have much room to run before it's forced to change course.
"Everything that's happening right now is limiting the scope for the ECB to really hike a lot," Carsten Brzeski, global head of macro at ING, told me.
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