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ECB weighs bigger rate hike with safety net for indebted countries

by jcp

By Francesco Canepa and Balazs Koranyi

FRANKFURT (Reuters) -European Central Bank policymakers are considering raising interest rates by a bigger-than-expected 50 basis points at their meeting on Thursday to tame record-high inflation, two sources with direct knowledge of the discussion told Reuters.

To cushion the impact of the higher borrowing costs, policymakers are also expected to announce a deal to help indebted countries like Italy on the bond market. The deal will require they stick to European Commission rules on reforms and budget discipline, the sources said.

The ECB is set to deliver its first rate hike in more than a decade on Thursday against a difficult economic backdrop exacerbated by the war in Ukraine. Inflation is high and rising while economic growth has slowed and a political crisis in Italy is keeping investors on edge.

That dynamic creates a balancing act for the ECB, between raising rates to curb price growth and ensuring that the most indebted of the euro zone’s 19 member countries don’t run into financial trouble as a result.

The sources, who spoke on condition of anonymity because the deliberations are private, said the discussion about whether to increase rates by 25 or 50 basis points was still wide open.

Other major central banks have been raising rates in bigger increments, such as 75 or even 100 basis points, raising the pressure on the ECB to do more.

But the risk of a recession in the euro zone, particularly if Russia turns off the taps to natural gas supplies, made some ECB governors more cautious about choking growth, the sources said.

An ECB spokesperson declined to comment, citing the bank’s pre-meeting quiet period.

The euro jumped on Tuesday after Reuters first reported that a 50 bp hike was under discussion, and was last up 0.9% against the dollar at $1.0232. The single currency briefly fell below parity last week.

Yields on euro zone government bonds also rose, with Germany’s two-year benchmark now yielding 1.329%.

The ECB said on June 9 after its last meeting that it would raise interest rates gradually, probably by 25 basis points in July with a bigger move possible in September.

But ECB chief Christine Lagarde later said there were “clearly conditions in which gradualism would not be appropriate”.

Euro zone inflation hit 8.6% last month and is expected to keep rising until the autumn, driven by soaring fuel and food prices. It is then seen slowly falling back but could hold above the ECB’s 2% target through 2024, raising the risk that wages will follow, setting off a hard-to-break wage-price spiral.

A Reuters poll of economists late last week found all but one expected the ECB to stick to its guidance and raise its deposit rate by 25 basis points this week, though a narrow majority said it should go for a bigger half-point hike.

That the ECB is even considering a half-a-percentage-point hike marks a turnaround after it insisted for weeks that a 25-basis-point move was the most adequate. It deliberations follow a hefty 75 bps rise by the U.S. Federal Reserve last month, which also ran against itw own guidance.

STRINGS ATTACHED

Rate setters will also announce a new bond-buying scheme on Thursday, aimed at capping member countries’ borrowing costs when they are deemed to be out of sync with economic reality – as it happened in early June in Greece, Italy, Spain and Portugal.

This programme was now seen as even more crucial as Mario Draghi’s government in Italy hung by a thread, raising the chances of early elections at which far-right Brothers of Italy might emerge as the biggest party according to recent polls.

Such political turmoil in Italy would likely trigger a sharp spike in the country’s bond yields.

The ECB is likely to make help conditional on countries meeting targets set by the European Commission for securing money from the European Union Recovery and Resilience Facility, the sources said.

They added countries will also be expected to stay within the Stability and Growth Pact’s budgetary constraints when they are reinstated next year after a suspension for the pandemic, the sources said.

Some policymakers had wanted to involve the European Stability Mechanism, the euro zone’s bailout fund created in the wake of the debt crisis a decade ago, but this option was now likely to be discarded, the sources said.

The ESM is not a European Union institution but an intergovernmental organisation owned by euro zone countries in proportion to the size or their economy and population, making Germany, France and Italy the biggest shareholders.

The sources stressed that any final decision on when to buy bonds would be taken by the ECB’s own Governing Council.

The ECB accelerated work on the new scheme in mid-June after a sudden flare-up in the bond market yields and premiums paid by peripheral countries as investors priced in the end of ECB asset purchases and the start of its rate-hiking cycle.

(Editing by Catherine Evans and Frank Jack Daniel)

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