Governor’s statement following the ECB’s monetary policy meeting

Developments in the euro area economy this year have been dominated by Russia’s military aggression, which has significantly hit economic activity and has driven inflation. Inflation is rising amid the turmoil on the commodities markets and the expansion of its base, but is mainly being driven by extremely high growth in energy prices and food prices.

In these circumstances the Governing Council of the ECB decided to take the next step in the normalisation of monetary policy, and to raise key interest rates by 50 basis points. The interest rate hikes and their impact on the financing conditions will prevent current inflation expectations from extending over the medium term. To maintain the uniform and homogenous transmission of the monetary policy stance across the entire euro area, a new instrument (the TPI) has also been established.

The economic situation in the euro area remained sound in the first half of the year amid high inflation, while the outlook for the third quarter suggests a slowdown in economic growth amid increased uncertainty. In light of the consequences of Russia’s military aggression, the turmoil on the energy markets, and the ongoing issues on the supply side, growth in demand expectations is slowing, and the economic sentiment also continues to cool. Despite all these risks, the euro area labour market is reflecting the comprehensive nature of the recovery that began following the relaxation of pandemic containment measures: May’s unemployment rate of 6.6% was the lowest since the introduction of the euro, and the labour shortage remains at a record level.

Russia’s military aggression, the strong cost pressures and the ongoing recovery in domestic demand are strengthening inflation and inflation expectations, which is passing through into the entire consumer basket. Year-on-year inflation in the euro area hit 8.6% in June. Strong energy price inflation remained the main driver, but the important role that energy plays in food production means that energy price rises are a major factor in food price inflation. As inflationary pressures widen, there is also a trend of rising core inflation, which stood at 3.7% in June. The cost pressure indicators all along the price chain remain at record high levels, an indication that inflation will remain elevated for some time yet.

The Governing Council of the ECB yesterday decided to take the next step in the normalisation of monetary policy, and to raise all three interest rates by 50 basis points. This decision is driven by the strengthened inflationary pressures and the rising inflation outlook. Further normalisation of monetary policy will also be appropriate in the future, while the exit from negative interest rates allows us to make a transition to a meeting-by-meeting approach to further changes in interest rates. These will depend on the actual course of events, and analysis presented at each meeting of the Governing Council.

With this decision – the first rise in interest rates in 11 years – the ECB is joining other central banks that have already decided to reduce the accommodative stance of monetary policy in light of the global inflationary pressures. The interest rate hike represents a major step in the normalisation of the monetary policy in the euro area, and a step in the direction of emergence from the period of non-standard measures. These were introduced over the last decade to combat the weak macroeconomic environment and below-target inflation following the global economic crisis, the European debt crisis and the pandemic crisis. The ECB’s non-standard measures (asset purchase programmes, longer-term refinancing operations and negative key interest rates) made a major contribution during the crises to ensuring that the financing conditions remained favourable, to maintaining price stability and to preventing damaging longer periods of deflation.

This action will ensure stable price growth that over the medium term provides the right conditions for businesses and households, and also for governments. The interest rate hikes will gradually feed through into the borrowing terms of households and businesses in Slovenia. Interbank interest rate benchmarks such as the Euribor are tied to the ECB’s key monetary policy interest rates, and the interest rates for households and businesses are in turn tied to the interest rate benchmarks. By raising the cost of borrowing, our expectation is that interest rates on savings in the form of deposits will also rise. The normalisation of monetary policy will also raise borrowing costs for the government, financing costs having been at record lows for governments, and also for households and businesses.

A new instrument was established to protect monetary policy transmission: the Transmission Protection Instrument or TPI aims to maintain the uniform and homogenous transmission of the monetary policy stance across the entire euro area, a prerequisite for meeting the inflation target.

The mere existence of the new instrument is supporting the normalisation of monetary policy.

Should a situation arise where the new instrument would actually be deployed, the purchases under the instrument would focus initially on public-sector securities with a residual maturity of one to ten years. Purchases will only be allowed in countries that:

• are not subject to an excessive deficit procedure, or are taking effective action in response to an EU Council recommendation to address an excessive deficit
• are not subject to an excessive imbalance procedure, or are taking effective action in response to an EU Council recommendation for corrective action
• show a high likelihood that the future trajectory of public debt is sustainable
• comply with the commitments submitted in the recovery and resilience plans

The scale of the purchases is not restricted ex ante, and will depend of the severity of the risks facing monetary policy transmission. The purchases will be undertaken in a way that does not affect the monetary policy stance. A decision to activate the instrument will be taken by the Governing Council on the basis of a comprehensive assessment.

The Governing Council decided in favour of the new instrument in a situation of increased volatility in market interest rates. This is the result of economic and geopolitical uncertainty, which could hinder the functioning of monetary policy transmission. The volatility has also been reflected in the government bond market. For example, from a peak of 2.8% on 14 June, the yield on 10-year Slovenian government bonds fell to around 2.3%, while the yield on the German benchmark fell from 1.75% to 1.3%. Share indices have stabilised after falling in recent months. Bank lending to businesses and households remains robust. Interest rates on bank loans have risen moderately in all euro area countries, but remain close to their record lows.

Banka Slovenije and the entire Eurosystem will continue monitoring the evolution of the macroeconomic environment and inflationary pressures. All of our instruments, including interest rates, will be tailored to the circumstances and to the macroeconomic and inflation outlook. At the same time Banka Slovenije will continue to adjust our own instruments, as far as we have the power to do so in macroprudential policy, to prevent the build-up of risks and thereby to ensure financial stability.

The ECB’s explanations can be found on this link.