Eurozone economy likely to contract

The central bank sees more weakness ahead as it hikes interest rates to fight inflation

The headquarters of the European Central Bank (ECB) is pictured in Frankfurt in western Germany.  The central bank of the 19-country euro zone raised its key interest rate by another half a percentage point on Thursday.  (AFP photo)

The headquarters of the European Central Bank (ECB) is pictured in Frankfurt in western Germany. The central bank of the 19-country euro zone raised its key interest rate by another half a percentage point on Thursday. (AFP photo)

FRANKFURT – The euro zone economy could contract in the last quarter of this year and the first quarter of next year due to high energy prices, but should still be able to cope with weak growth in 2023, the European Central Bank (ECB) said on Thursday.

Gross domestic product would rise 0.5% for 2023, the bank forecast, up from its previous forecast of 0.9%. Stronger growth of 1.9% should then be achieved for 2024, it said.

The ECB also raised its benchmark interest rate by half a percentage point, the fourth straight hike, and outlined plans to trim its bloated balance sheet from March on hopes that higher borrowing costs will finally halt runaway inflation.

The central bank of the euro-zone’s 19 countries raised its deposit rate to 2% as expected and kept further hikes on the table as new economic forecasts suggested it would take years to bring price growth back to 2%.

The ECB’s interest rate decision, along with similar actions by the Federal Reserve and Bank of England this week, may reflect a belief that the worst inflation in a generation – if not over – is at least about to peak. This could also put the upper limit for borrowing costs in sight.

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The ECB has hiked interest rates by a total of 2.5 percentage points since July, the fastest monetary tightening on record, to stem inflation, which was pushed above 10% this fall by rising food, energy and now services prices .

“Based on the significant upward revision of the inflation outlook, it is expected to be raised further,” the ECB said in a statement.

The next step in the ECB’s monetary tightening will be a reduction in its €5 trillion hoard of bonds bought as it tried to stimulate economic activity, making borrowing more expensive for companies and governments.

From early March 2023, the portfolio will shrink at a measured and predictable pace,” the ECB said. “The decline will average €15 billion per month by the end of Q2 2023.”

This process will increase longer-term borrowing costs, while more traditional rate hikes tend to increase short-term funding costs.

The ECB has already reduced its balance sheet by withdrawing €800 billion of ultra-cheap funding from banks, but its €8 trillion balance sheet remains exceptionally large by historical standards.

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