10 reasons why the ECB can keep interest rates on hold

Minimum reserves, balance sheet and ‘what happens next’

The European Central Bank is learning the art of the trade-off. Its decision on 14 September on whether to raise interest rates one more time in its 14-month tightening cycle is one of the most thorny in the ECB’s 25-year history. As it stands, opinion is divided on the 26-person ECB council.

Christine Lagarde, ECB president, and other council members wish to maintain harmony over the ECB’s next step as a crucial way of safeguarding its credibility. This gives different forms of bargaining advantage to the diverse sections of the council. If they operate adroitly, there are acceptable possibilities for delicate compromises.

Should the 27 July rise in the key deposit rate to 3.75% be the last in the series? Or should there be one last push to 4%? Here are 10 reasons why a halt in the rate-tightening cycle makes sense.


  1. Inflation starting to come under control

ECB officials have been fervently stating that interest rate decisions will be ‘data dependent’. Latest figures showing the euro area’s headline and core inflation gradually decelerating to 5.3% in August – although still well off the 2% target – provide just enough evidence to justify ‘no rise’. Updated projections are expected to show probabilities hardening that inflation will be 2% by 2025.

  1. Euro area close to recession

Weakening economies – particularly three consecutive months of falling industrial production in Germany – and slackening credit activity underline how ECB tightening is working through to the real economy. The central bank started late, reflecting 2021 complacency about ‘transient’ inflation. But hawkish decisions, with the normal lag of up to 18 months, are reverberating throughout Europe.

  1. ECB attempting to master trade-off despite challenges

Increasingly subtle governing council decision-making should allow the ECB’s ‘pro-tightening’ faction powerful compensation in return for keeping rates on hold. Lagarde would have to persuade the public and financial markets that maintaining a 3.75% level does not signify imminent rate reductions. This could even foreshadow rises later if inflation proves unexpectedly stubborn. A difficult – but not impossible – communication task.

  1. Zero-remunerated minimum reserves playing stronger role

Spurred by the Bundesbank, the council is deliberating on whether the level of required bank reserves – non-interest-bearing following the council’s 27 July decision to lower minimum reserves remuneration to zero – should be raised from 1% to 2% of liabilities. That would return the percentage to the 2011 level. The Bundesbank sees greater reliance on minimum reserves as a ‘modern’ instrument – another important trade-off in the policy balance.

  1. Keeping an eye on the balance sheet

The ECB and shareholder central banks are lowering the Eurosystem balance sheet that has been bloated by eight years of quantitative easing. After smooth summer repayment of bank refinancing operations, excess bank reserves have fallen from €5tn to €3.6tn. Keeping interest rates unchanged can be accompanied by further measures governing Eurosystem portfolios of different categories of government bonds. A sophisticated way of telling markets what may happen next will be to say interest rates can be cut only after the ECB advances further in reducing government securities holdings – a key additional trade-off.

  1. Bank of England and Fed show the way

Reference by Huw Pill, Bank of England chief economist, to a ‘table mountain’ scenario for a UK rate plateau – since backed by Andrew Bailey, BoE governor – may act as a useful guidepost for ECB deliberations. Catherine Mann, the BoE’s doughtiest inflation-fighter, is likely to remain in the minority with her view that British tightening should continue. There will be a similar effect on the ECB from indications by Christopher Waller, a Federal Reserve board member, that the US will proceed carefully over any further tightening.

  1. Outlier Germany should look after itself

A sizeable number of council rate-setters will not wish to give undue consideration to Germany’s inflation rate of more than 1 percentage point above the euro area average. Higher German inflation can help lower traditional euro area differences. If Germany needs to damp its own inflation rate, it should rely on structural national policies, not further euro-wide tightening.

  1. Beware lessons of 2011

The episode of undue euro area tightening in summer 2011 plays an important role in the ECB’s folk-memory. Interest rate increases were promptly reversed when Mario Draghi, Lagarde’s processor, became president in November 2011. Very few on the council wish to risk the damaging loss of credibility that could stem from a repeat.

  1. Paying attention to Italy

Italian politicians have shown disquiet over the ECB’s recent tightening. At end-October, Fabio Panetta, a member of the ECB’s six-person board, is returning to Rome to become governor of Banca d’Italia. This is only the second time since the ECB started in 1998 that a board member has left to become a national central bank governor. During the transition, the ECB may wish to adopt a steady hand. Panetta will volubly defend the line of Ignazio Visco, the present governor, that the risk of ‘too much’ credit tightening outweighs that of ‘too little’. A nuanced version of the Visco-Panetta doctrine looks to carry the day.

  1. Don’t mention the losses

The Bundesbank is likely to return to profitability only in 2028-29, later than postulated in a July International Monetary Fund report, apparently because the German central bank is making less benevolent assumptions than the IMF. These losses come as a delayed consequence of QE. The Bundesbank can carry out various balance sheet adjustments to avoid negative equity. Profit considerations play no formal role in monetary policy. However, purely arithmetically, avoiding further rises in the deposit rate will help central bank profitability.

David Marsh is Chairman of OMFIF.

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