ECB governors see rising risk of rate hitting 2pc to curb record-high inflation

PRAGUE: European Central Bank policymakers see a rising risk that they will have to raise their key interest rate to 2 percent or more to curb record-high inflation in the euro zone despite a likely recession, sources told Reuters.

With inflation hitting 9.1 percent in August and seen above the ECB's 2 percent target for two years to come, the central bank has been raising its interest rates at record speed and urging governments to help bring down energy bills that have ballooned since Russia invaded Ukraine.

The ECB raised its deposit rate from zero to 0.75 percent on Thursday and President Christine Lagarde guided for another two or three hikes, saying rates were still far away from a level that will bring inflation back to 2 percent.

Five sources close to the matter said many policymakers saw a growing probability that they will need to take the rate into "restrictive territory", jargon for a level of rates that causes the economy to slow, at 2 percent or above.

The sources, who spoke on condition of anonymity because policy deliberations are private, said this would most likely happen if the ECB's first inflation projection for 2025, due to be published in December, is still above 2 percent.

An ECB spokesman declined to comment.

The ECB currently sees inflation at 2.3 percent in 2024, though one source said an internal forecast which was presented at Thursday's meeting put it closer to 2 percent after taking into account the latest gas prices.

Dutch central bank governor Klaas Knot and Belgium’s Pierre Wunsch were the first to openly talk about going into restrictive territory late last month, at a time when most of their colleagues felt interest rates just needed to go back to between 1 percent and 2 percent.

The sources said policymakers were bracing for a recession this winter and weaker economic growth next year than the ECB's official projection of 0.9 percent. But some took comfort from the strong labour market, which should cushion the impact of the higher rates, they added.

At Thursday's meeting, policymakers also began a discussion about the tens of billions of euros that the ECB is liable to pay out to banks on their excess reserves now that the deposit rate is positive again, the sources said.

Policymakers judged that current proposals, including one for a "reverse tiering system" that caps remuneration on some reserves, needed more work, the sources said. One added a decision might still come before the ECB's next policy meeting on October 27.

Debt reduction paths

Meanwhile, the European Commission will present in the second half of October proposed changes to European Union fiscal rules that are likely to offer countries individual debt reduction paths, Commission Vice President Valdis Dombrovskis said on Saturday.

At a news conference after EU finance ministers held talks in Prague, Dombrovskis said the main goal of the rules, designed to safeguard the value of the euro would remain making sure public debt was sustainable.

"This will require fiscal adjustment, reforms as well as investments," Dombrovskis said, signalling government investment was likely get some more attention in the course of the reform.

"Those three elements should all be combined so as to achieve a realistic, gradual and sustained reduction in public debt ratios," he said.

EU rules say public debt must be below 60 percent of gross domestic product (GDP) and government deficits below 3 percent of GDP.

But the pandemic left many countries with debt well above 100 percent of GDP, with Greece at around 185 percent and Italy around 150 percent. On the other hand, Estonia has a debt of only 18.1 percent, Luxembourg 24.4 percent and Lithuania 44.3 percent.

"Given divergent debt levels across Member States, there cannot be a one-size-fits-all approach," Dombrovskis said. "There can be more leeway for Member States, but within a common set of rules," he said.

This would be a departure from the current rule that all countries have to cut their debt every year by one twentieth of the excess above 60 percent of GDP - a requirement that is far too ambitious for the high debt countries.

"Rules have to be clear, and they have to be enforceable, that means they have to be realistic," Czech Finance Minister Zbynek Stanjura, who hosted the meeting, said. "So whatever changes we make, we have to work out what is realistic."

In a nod towards Germany and some northern EU countries, the Commission will propose stronger enforcement of the rules in cases of non-compliance, Dombrovskis said, as past practice showed adhering to the rules was not a priority for some.

The Commission will also propose simplifying the rules by focusing on a single observable indicator, such as the expenditure benchmark, Dombrovskis said.

The expenditure benchmark is a rule that allows governments to increase spending each year by the rate of the economy's potential growth - the rate at which an economy grows without generating excess inflation. This way, when the economy is growing faster than potential and overheating, the lower spending helps to cool it. When the economy is growing below potential, the higher government spending helps it catch up.