MNI STATE OF PLAY: ECB To Hike, Reveal New Crisis Tool

The European Central Bank is set to stick to its recent guidance and increase its deposit rate by 25 bps to -0.25% on Thursday, its first hike in more than a decade, and confirm a further increase of maybe 50 bps to follow in September even as downside risks to growth become more evident.

Although some members will argue for a 50 bps hike this week, pointing to eurozone inflation running at 8.6%, the Governing Council’s intention to hike by 25 bps in July was laid out clearly in the June policy statement, with a commitment to a larger increase at the first post-summer meeting "if the medium-term inflation outlook persists or deteriorates." ECB President Christine Lagarde, VP Luis de Guindos and Bank of Finland Governor Olli Rehn have been amongst those repeating the guidance in recent days.

Still, there have been plenty of calls for a 50 bps hike this week, with Austrian central bank head Robert Holzmann the most vocal. Two of the Baltic state central bank chiefs have called for a larger hike as well, with inflation at 20% in their region. But while hawkish dissenters will get their message into the official record, it is likely they will have to wait until September for the bigger increase.

ITALIAN CHALLENGE

But even as the ECB prepares to tighten policy, downside risks to growth are becoming more evident. Russia could turn off gas supplies to Europe and Italy could face autumn elections if the government of prime minister and previous ECB head Mario Draghi collapses as early as this week.

Italian politics will focus attention on the other main policy announcement expected Thursday -- the likely unveiling of at least some details of the ECB's anti-fragmentation tool. The Transmission Protection Mechanism, to give it its apparent working title, is meant to be the Governing Council's backstop to deal with any excessive widening of bond spreads over Germany’s benchmark bunds.

The tool will not be explicitly designed to deal with the market fallout from political turbulence, but events in Rome will pose a test for the ECB as it tries to put more flesh on its statement made after the June 15’s 'ad hoc' policy meeting, even as policy makers will be eager to avoid offering Italy’s competing political parties any opportunity to promise to spend more money.

It is not clear how much detail of the tool will be announced, as MNI has reported, but there will be hope in Frankfurt that financial markets will be convinced of the central bank’s determination to do 'whatever it takes' to prevent any divergence of government borrowing costs which interferes with the transmission of monetary policy. (See MNI SOURCES2: September Hikes From 25-75Bps On Table For ECB)