As was widely anticipated, the ECB became the first of the major central banks to raise interest rates in the current cycle. Futures trading suggests another two or three 25 basis point rate hikes by the end of 2011. The ECB, traditionally hawkish on inflation, has decided to tighten monetary policy in response to rising cost pressures emanating from global commodity markets, and also some signs of domestically generated inflation, particularly in the strengthening German labour market in which the recent trend is towards higher pay settlements. A number of ECB policy-makers will be relieved that the normalization of interest rates in the Euro area has started and that the central bank is at least seen to be making gestures consistent with its primary goal of inflation stability, even if it is sometime until inflation is returned to target levels.
However, in a number of other ways the latest ECB move could make the future even more uncomfortable for some of the more conservative members of the policy committee. One reason is that rising interest rates are likely to pile even more pressure on the ECB to continue purchasing the bonds of peripheral Eurozone nations currently facing financing problems. The ECB has always been reluctant to enter the fight against bond market vigilantes, fearing the capital losses it may face on distressed assets, but has been forced into such a role in the absence of an established mechanism for helping states facing funding constraints (current efforts to convert the bail-out fund into a permanent stability mechanism seemingly lack the required resources, so the ECB is likely to have to fill its new role for some time to come). The tightening of monetary policy starting with the latest rise in interest rates is likely to intensify bond market problems and increase the demands on the ECB in at least two ways. Firstly, monetary tightening will slow the economies of peripheral Europe, impeding fiscal retrenchment and investor confidence in their sovereign debt. Secondly, rate rises will accelerate loan losses facing struggling banks in countries such as Spain and Ireland, which in turn will increase the cost of any public role in bank re-capitalization and hence the overall financing requirements of the countries concerned. Both factors will serve to extend the duration of support buying in bond markets by the ECB. In addressing a perceived inflation problem with interest rate rises the ECB will find it harder to withdraw from some of the unconventional operations it has been forced into since the onset of the financial and sovereign debt crises.
The second reason that the ECB is set to make life harder for itself is that the costs of sterilizing asset purchases will be higher going forward. The ECB has tried not to engage a policy of quantitative easing in the sense of expanding its balance sheet, a la the Fed and BoE, but has instead tried to drain from other parts of the financial system the liquidity it injects via bond purchases. This has been attempted (not always successfully) via short-term deposits at the ECB intended to tie down liquid funds in the market. In the future, the general rise in market interest rates will increase the cost of absorbing market liquidity in this way. To the extent that full sterilization of bond purchases cannot be achieved as a result of this rising cost, there is the potential for excess liquidity in the Euro area to drive growth in the broader money supply, potentially leading to the future inflation that interest rate increases are designed to address.
A third tension likely to arise from the ECB's policy move is that, to the extent the interest rate rise forces increased stress on banks in the periphery, the demand for the main facility introduced by the ECB in response to the financial crisis, the commitment to provide unlimited loans for up to 12 months to European banks in return for a wide range of collateral, will increase. The ECB ultimately intends to withdraw this facility, in order to ensure that the market and not the central bank guide medium-term capital allocation, but that withdrawal may have to happen rather later than planned if the start of the up phase in the interest rate cycle increases commercial bank dependence on the funding lines operated by the ECB.