ECB Being Pulled in Multiple Directions as It Prepares First Rate Rise in a Decade

At the same time, she must convince investors that a major new policy tool, likely to be unveiled Thursday, can shield vulnerable Southern European economies from the risk of spiraling borrowing costs as the ECB moves to raise rates.

And she needs to convince hawkish ECB officials, and some critical member states, that those plans are robust and legally watertight.

The need to balance these three goals means the bank needs to calibrate its response to surging inflation more delicately than the Fed, possibly limiting its effectiveness. It also means the ECB could effectively be raising rates for some borrowers while pushing them down or keeping them flat for others.

The tension spilled out into the open on Tuesday when people familiar with the matter said that ECB officials would likely discuss a half-point rate increase this week—larger than the quarter-point increase that Ms. Lagarde had carefully telegraphed for weeks.

Compared with other central banks, the ECB is moving slowly to phase out easy money. While the ECB’s key rate is still set at minus 0.5%, an all-time low, the Fed is expected to raise its policy rate by 0.75 percentage point later this month to a range between 2.25% and 2.5%. Inflation has risen close to 9% on both sides of the Atlantic, and shows few signs of retreating in either region. Canada’s central bank last week increased its target interest rate by a full percentage point, to 2.5%, the highest level since 2008.

The ECB’s caution helped to drive the common currency to a 20-year low against the dollar in recent days, which raises the cost of Europe’s imports and makes it even harder for the ECB to stifle inflation.

“In hindsight, the very gradual and cautious normalization process the ECB started at the end of last year has simply been too slow and too late,” said

Carsten Brzeski,

an economist with ING Bank in Frankfurt.

To be sure, the eurozone’s economic outlook is clouded by the war in Ukraine. European officials fear that Russian President

Vladimir Putin

won’t restart gas supplies to Europe through the Nord Stream 1 pipeline on Thursday after they were cut off for scheduled maintenance, which could trigger a deep recession in parts of the continent.

And while the Fed is squarely focused on combating inflation, ECB officials need to worry about how higher interest rates will reverberate across the currency union, whose members range from Germany to Latvia to Greece. The government in Italy, the region’s third largest economy, has been in turmoil since Prime Minister

Mario Draghi,

Ms. Lagarde’s predecessor as ECB president, tendered his resignation, though he said Wednesday he would stay on if he wins confidence votes in Parliament.

The ECB’s recent experience with interest-rate increases invites caution. After raising rates in 2008 and 2011, the ECB had to quickly reverse course as the bloc tumbled into recession. Part of the problem was that government bond yields and borrowing costs rose more sharply in Southern Europe than in Northern Europe. Countries like Greece and Spain suffered sharper and longer-lasting downturns than Germany or France.

These differences are partly inherent in the design of the currency area, which binds sovereign countries with their own fiscal policies and whose economic and financial health vary. Yet too much divergence in borrowing costs can make it hard for some economies to grow under a unified monetary policy, threatening the bloc’s cohesion.

A decade ago, Mr. Draghi ended the eurozone debt crisis by promising to do “whatever it takes” to preserve the euro. The ECB subsequently unveiled a plan, known as Outright Monetary Transactions, to buy eurozone government debt in potentially unlimited quantities, which has never been used.

In a context of tightening monetary policy, high inflation and jittery markets, this protective shield is losing power. When Ms. Lagarde said in early June that the ECB would increase interest rates by a modest quarter point this month, sovereign-bond yields rose across Southern Europe.

Days later, ECB officials convened an emergency meeting and hashed out a plan to create a new bond-buying tool that could shield the south from higher borrowing costs.

Such a tool is needed, Ms. Lagarde argues, to ensure the “orderly transmission” of ECB interest-rate changes to firms and households across the currency zone. She is expected to unveil details of the new bond-buying program on Thursday. To convince investors, the program will need to be unlimited in size and come with easier conditions for governments than the OMT plan, analysts say.

Investors will also want to see that all ECB officials support the program, including German Bundesbank President

Joachim Nagel,

who has signaled concern that it might encourage excessive government borrowing. A ban on the ECB engaging in monetary financing of governments means it is almost certain to face legal challenges, especially in Germany, which could potentially nix the program if it isn’t carefully designed.

Write to Tom Fairless at [email protected]

At the same time, she must convince investors that a major new policy tool, likely to be unveiled Thursday, can shield vulnerable Southern European economies from the risk of spiraling borrowing costs as the ECB moves to raise rates.

And she needs to convince hawkish ECB officials, and some critical member states, that those plans are robust and legally watertight.

The need to balance these three goals means the bank needs to calibrate its response to surging inflation more delicately than the Fed, possibly limiting its effectiveness. It also means the ECB could effectively be raising rates for some borrowers while pushing them down or keeping them flat for others.

The tension spilled out into the open on Tuesday when people familiar with the matter said that ECB officials would likely discuss a half-point rate increase this week—larger than the quarter-point increase that Ms. Lagarde had carefully telegraphed for weeks.

Compared with other central banks, the ECB is moving slowly to phase out easy money. While the ECB’s key rate is still set at minus 0.5%, an all-time low, the Fed is expected to raise its policy rate by 0.75 percentage point later this month to a range between 2.25% and 2.5%. Inflation has risen close to 9% on both sides of the Atlantic, and shows few signs of retreating in either region. Canada’s central bank last week increased its target interest rate by a full percentage point, to 2.5%, the highest level since 2008.

The ECB’s caution helped to drive the common currency to a 20-year low against the dollar in recent days, which raises the cost of Europe’s imports and makes it even harder for the ECB to stifle inflation.

“In hindsight, the very gradual and cautious normalization process the ECB started at the end of last year has simply been too slow and too late,” said

Carsten Brzeski,

an economist with ING Bank in Frankfurt.

To be sure, the eurozone’s economic outlook is clouded by the war in Ukraine. European officials fear that Russian President

Vladimir Putin

won’t restart gas supplies to Europe through the Nord Stream 1 pipeline on Thursday after they were cut off for scheduled maintenance, which could trigger a deep recession in parts of the continent.

And while the Fed is squarely focused on combating inflation, ECB officials need to worry about how higher interest rates will reverberate across the currency union, whose members range from Germany to Latvia to Greece. The government in Italy, the region’s third largest economy, has been in turmoil since Prime Minister

Mario Draghi,

Ms. Lagarde’s predecessor as ECB president, tendered his resignation, though he said Wednesday he would stay on if he wins confidence votes in Parliament.

The ECB’s recent experience with interest-rate increases invites caution. After raising rates in 2008 and 2011, the ECB had to quickly reverse course as the bloc tumbled into recession. Part of the problem was that government bond yields and borrowing costs rose more sharply in Southern Europe than in Northern Europe. Countries like Greece and Spain suffered sharper and longer-lasting downturns than Germany or France.

These differences are partly inherent in the design of the currency area, which binds sovereign countries with their own fiscal policies and whose economic and financial health vary. Yet too much divergence in borrowing costs can make it hard for some economies to grow under a unified monetary policy, threatening the bloc’s cohesion.

A decade ago, Mr. Draghi ended the eurozone debt crisis by promising to do “whatever it takes” to preserve the euro. The ECB subsequently unveiled a plan, known as Outright Monetary Transactions, to buy eurozone government debt in potentially unlimited quantities, which has never been used.

In a context of tightening monetary policy, high inflation and jittery markets, this protective shield is losing power. When Ms. Lagarde said in early June that the ECB would increase interest rates by a modest quarter point this month, sovereign-bond yields rose across Southern Europe.

Days later, ECB officials convened an emergency meeting and hashed out a plan to create a new bond-buying tool that could shield the south from higher borrowing costs.

Such a tool is needed, Ms. Lagarde argues, to ensure the “orderly transmission” of ECB interest-rate changes to firms and households across the currency zone. She is expected to unveil details of the new bond-buying program on Thursday. To convince investors, the program will need to be unlimited in size and come with easier conditions for governments than the OMT plan, analysts say.

Investors will also want to see that all ECB officials support the program, including German Bundesbank President

Joachim Nagel,

who has signaled concern that it might encourage excessive government borrowing. A ban on the ECB engaging in monetary financing of governments means it is almost certain to face legal challenges, especially in Germany, which could potentially nix the program if it isn’t carefully designed.

Write to Tom Fairless at [email protected]