In January, headline inflation in the euro zone reached a new high with energy costs increasing at an unprecedented pace. This data will likely embolden ECB hawks to continue with further rate increases.

On Thursday, the European Central Bank raised its key interest rates by a half-point as it warned of persistent price pressures across all economies. They promised to raise rates another 50 basis points in March and then assess their monetary policy course going forward.

The ECB’s rate-tightening cycle

A central goal of the European Central Bank's monetary policy is to maintain inflation near 2%. They do this by setting key interest rates and managing money supply on the market. Generally, low key interest rates stimulate economic activity while higher ones stifle it.

In the Euro Area, inflation is measured by the Harmonised Index of Consumer Prices (HICP). This index takes into account all consumer prices within the eurozone and weighs them together to create one overall figure. Its main components are food, alcohol and tobacco products; energy; non-energy industrial goods; as well as services.

According to the HICP, eurozone inflation rates have been relatively low for a long time but have recently begun to increase. They are forecasted to reach 2.3% in 2024 and 2.4% in 2025 - closer to ECB targets of 2% inflation.

However, inflation could still increase further due to rising energy costs, disruption to supply chains and the conflict in Ukraine.

Since July, the European Central Bank (ECB) has raised its benchmark interest rate a total of 3 percentage points to combat inflation. As a result, inflation is being held in check and they've indicated they will keep raising rates at an incremental pace with sufficient restrictions in place. Last week's increase of 50 basis points and another 75 basis point hike are likely next month, taking us up to our current peak interest rates of around 3.75%.

Even after the European Central Bank (ECB) raised interest rates, inflation data remains weak. While headline inflation eased slightly in January, core prices (excluding volatile items such as food and fuel) rose more than expected, pushing the eurozone's overall inflation rate up to 5.3% from 5.2%.

This is an alarming indication, as it implies underlying inflation is rising and markets are pricing in longer-term inflation at around 2.4%. This implies the ECB may not have been able to contain inflation at this level.

The ECB’s inflation outlook

Inflation has been rising at its fastest rate in half a century in the euro zone due to rising energy costs. This has severely cut into consumer purchasing power and prompted the European Central Bank (ECB) to raise rates three times this year.

The bank predicts inflation will reach its 2% target in 2023, though it remains uncertain how much room for rate hikes after March 2020. Furthermore, wage growth remains strong and there are few signs of an economic slowdown.

At its latest monetary policy meeting, the European Central Bank (ECB) declared a record increase in interest rates - lifting all key rates by three-quarters of a percentage point and signalling that it may raise them again later this year. This move comes amid rapidly escalating price pressures caused by both the conflict in Ukraine and surging energy costs.

At the same time, the ECB declared it would continue buying government bonds under its asset purchase program until October 2022 to support prices and mitigate recession risks. This decision contrasted with Governing Council guidance in December 2021 which indicated asset purchases would cease after October.

It's essential to remember, however, that the ECB's forward guidance was data-dependent and date-dependent. To meet its requirements for expansionary monetary policy, headline inflation must increase to 2%, and core inflation should also surpass their own forecast of 3.0%.

In November, both the ECB's monthly asset purchase amounts and medium-term staff forecast for headline inflation increased. At the same time, core inflation hit more than 2% level and the ECB Governing Council unanimously voted in favour of raising interest rates.

Headline eurozone inflation is likely to decline in December as high energy costs eased and buying power recovered. However, the core gauge that excludes volatile items will likely hold at a record 5.3%. Despite their cautious outlook, ECB officials remain determined not to let inflation revert back to its long-run trend of around 2.0% and trigger an economic downturn across the region.

The ECB’s rate-tightening strategy

Recently, the European Central Bank (ECB) has had to walk a fine line between increasing borrowing costs enough to control inflation without depressing demand too much that it sparks an economic downturn. Its aim is to guarantee eurozone prices return to their 2% target level within two to three years.

Since July, the European Central Bank (ECB) has raised rates by a total of 300 basis points - marking its fastest rate hike cycle ever. Nonetheless, many analysts question whether this current hike cycle will prove lasting.

One reason is that monetary policy tightening is often driven by the pipeline effect. In other words, the ECB's rate increases are only effective when combined with other economic elements like wage growth or government support programs.

This presents a challenge for the European Central Bank (ECB), since it's difficult to judge whether its monetary policies are actually helping reduce inflation. Although inflation has fallen from its highs, the rate increases from the ECB remain rapid - they're expected to keep increasing rates until 2023.

Analysts anticipate ECB policymakers will take heart from November's eurozone inflation data, which showed prices declining for the first time in 17 months due to lower energy costs. They could therefore decide to slow down their rate increases, according to analysts.

It is essential to remember that a sustained period of rising inflation could prompt the European Central Bank (ECB) to raise its deposit rate beyond what financial markets currently expect. This is because real interest rates must surpass 2% in order to prevent inflation from ever exceeding the ECB's 2% target level in future years.

However, if the ECB continues to raise interest rates at an unprecedented pace, it could erode credibility with investors and set off a negative feedback loop that would require even further rate hikes in order to combat price pressures which might further depress demand. In such an eventuality, consumers could experience yet another recession and loss of faith in the central bank.

The ECB’s rate-tightening path

As the European Central Bank's rate pressures mount ahead of eurozone inflation data, many questions remain. While the ECB wants inflation back at its target level of 2%, it will need to raise interest rates significantly and gradually in order to accomplish this objective.

The European Central Bank (ECB) has raised its deposit rate by 50 basis points since December and it's expected to do so again in March. The Governing Council, composed of six members from the Executive Board and 19 national central-bank governors from member countries, meets twice a month to decide on monetary policy strategy.

Though recent signs suggest price pressures have eased, the European Central Bank (ECB) remains committed to targeting a peak rate of 3.25%/3.50% by summer. This would be its highest ever target and well beyond what many economists consider reasonable given the current economic uncertainty.

Inflation in the euro area, including energy and food costs, reached a new high in December but remains well below the European Central Bank's target of 2%. The bank has pledged to maintain its monetary policy until inflation reaches that goal; additionally, their staff have revised up their inflation projections for the region.

These new forecasts suggest the European Central Bank (ECB) can bring inflation back to its target of 2% by 2025, suggesting it may need to begin reversing its quantitative easing program (QE) sooner than previously believed.

However, the European Central Bank's aggressive approach to combatting high inflation could prove counterproductive. If they continue raising their deposit rate too rapidly, it could eventually cause an abrupt decrease in economic growth.

This can put undue strain on the economy and put financial instability at risk. The ECB should only raise its deposit rate aggressively when it is confident that the economy has stabilized, and can do so without endangering European stability.

The ECB has pledged to address fragmentation risks in the bond market, which have been driving up government debt in peripheral nations. Additionally, they are considering the size and duration of a new bond-buying scheme to combat diverging borrowing costs among Eurozone governments.