European Central Bank Slows Pace of Rate Increases

ECB indicates it isn’t ready to pause its campaign against inflation, diverging from the Fed

The European Central Bank slowed the pace of its interest-rate increases but signaled it isn’t ready to pause its campaign against high inflation, diverging from the Federal Reserve.

In a statement, the ECB said it would increase its key rate by a quarter percentage point, to 3.25%, a near 15-year high. It was the smallest move since the bank started raising rates last July. The bank also said it would reduce its bond holdings at a faster pace starting in July, a move that is likely to weigh further on economic growth and inflation.

The ECB’s decision to move more slowly in raising borrowing costs comes after the Fed nudged rates higher on Wednesday but signaled a potential pause in monetary tightening.

Investors expect the ECB to continue raising rates over the coming months even as they anticipate interest-rate cuts from the Fed. The emerging divergence between the two major central banks has been reverberating through financial markets, recently driving the euro to its highest level against the dollar in more than a year.

The shift to a slower pace of rate increases was “based on the understanding that we have more ground to cover and we are not pausing,” ECB President Christine Lagarde said at a news conference.

“We all concluded that the inflation outlook is too high and has been so for too long,” Ms. Lagarde said of Thursday’s policy meeting. Some officials advocated a larger half-point rate increase, she said.

The ECB started raising rates later than the Fed, and rates in the eurozone lag behind those in the U.S. Still, analysts said the ECB was probably closer to the end of its interest-rate cycle than Ms. Lagarde suggested.

“The step down in the pace of interest rate rises is a signal the ECB does not want to risk overdoing it, is seeing some signs the economy is starting to cool and is mindful of spillovers from U.S. banking sector fragilities to European credit conditions,” said Katharine Neiss, a former Bank of England economist who is now chief European economist at PGIM Fixed Income.

Investors responded to the decision by lowering their expectations for future ECB interest rate increases. The euro fell 0.5% to $1.1003, signaling that investors see more limited divergence between the ECB and the Fed. European government borrowing costs also declined, with the yield on the 10-year German bund down to 2.192% from 2.282% before the announcement. European stocks pared some earlier losses, with the pan-continental Stoxx Europe 600 ending the day down 0.5%.

Like the Fed, the ECB is trying to balance the need for tighter monetary policy to curb stubbornly high inflation against the risk of going too far in an environment of weak growth and banking-sector turmoil. For months, the ECB has had to raise rates while taking care not to cause a deep recession in a currency bloc shaken by Russia’s invasion of Ukraine, or to destabilize its most indebted nations, whose borrowing costs have rocketed.

With the ECB’s key rate now at a level that is likely to constrain economic growth, some officials have signaled the need to move cautiously from here. They say their policy acts on the economy with a lag, meaning that the full impact of rate increases won’t be felt for some months.

“They’ve done 350 basis points [of policy tightening] in a very short period of time, and monetary policy obviously operates with a lag, so a lot of the effects will still filter through into the real economy,” said Konstantin Veit, a portfolio manager at Pimco.

Thanks to declining energy prices and the reopening of China’s economy, the eurozone is expected to eke out weak growth this year, averting the deep recession many economists predicted after Russia’s invasion of Ukraine last year. There are few signs so far of spillovers from bank turmoil in the U.S. and Switzerland, following the failure of Silicon Valley Bank and the acquisition of Credit Suisse Group by Swiss peer UBS Group in March.

Still, a closely watched ECB survey indicated this week that demand for corporate lending and housing loans had declined the most since the 2008-09 global financial crisis or earlier, signaling that the ECB’s interest-rate hikes are having their intended effect of cooling down the economy. Underlying inflation in the eurozone ticked down slightly to 5.6% in April from a record of 5.7% the previous month, matching the core inflation rate in the U.S.

In the U.S., Fed officials signaled on Wednesday that they might be done raising interest rates for now after approving another increase of the federal-funds rate to a range between 5% and 5.25%, a 16-year high.

Analysts say the ECB will likely need to see more evidence of easing price pressures before it stops increasing rates, even if leading indicators are moving in the right direction.

Ms. Lagarde warned on Thursday that underlying price pressures remained strong and that wages were rising sharply.

Investors bet after Ms. Lagarde’s news conference that the ECB would raise rates by only another quarter point, to 3.5%, down about 0.1 points from their prediction earlier in the day, according to data from Refinitiv. They expect the Fed to reduce interest rates by about 0.8 points later this year, to about 4.2%, the data show.

While the ECB is likely to pause its rate increases in the summer, the tightening so far is unlikely to be enough to bring inflation back to its 2% target in a sustainable way, said Joerg Kraemer, chief economist at Commerzbank in Frankfurt.

“Inflation tends to get stuck at high levels,” Mr. Kraemer said. Overcoming that “requires decisive countermeasures. An ECB [key] rate of 3.5% is probably not enough.”