London Daily

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Friday, Oct 02, 2026

The ECB was in a real bind over interest rates – but the Fed and Bank of England's task is slightly easier

The ECB was in a real bind over interest rates – but the Fed and Bank of England's task is slightly easier

Europe's monetary policy regulator could have sparked a big sell-off in European shares had it shied away from a 0.5 percentage points rise which the market had expected earlier this week.
The European Central Bank was in an incredibly difficult position ahead of today's interest rate decision.

Inflation in the eurozone is still running at 8.5% - more than four times the ECB's target rate - while the 'core' rate of inflation, which strips out volatile elements such as energy, food, alcohol and tobacco, actually rose from 5.3% in January to 5.6% in February.

Under those circumstances, markets had fully priced in a rise in the ECB's main policy rate from 2.5% to 3%.

Then came the collapse of Silicon Valley Bank, America's 16th largest lender, sparking turmoil in banking shares and equity markets initially in the US and then, during the last 48 hours, in Europe.

The headline act here was Credit Suisse, the accident prone Swiss lender, whose share price fell in Zurich by 24% on Wednesday.

The ECB, as a key player in the maintenance of financial stability in the eurozone, might then have been forgiven for pausing to take stock of the situation.

It has emerged that it has been informally asking some of the eurozone's major lenders during the last 48 hours about their exposure to Credit Suisse.

Rare and dramatic market moves

Accordingly, some market participants began reassessing the prospects of a half-point interest rate rise this week.

The market began to price in a quarter-point, not half-point, rate hike.

Nowhere was this more apparent than in the market for eurozone government bonds.

The yield - an implied borrowing cost - on two-year German government bonds plunged from 3.277% last Friday morning to as low as 2.373% this morning.

Similarly, the yield on two-year French government bonds slid from 3.1788% last Friday night to as low as 2.5080% on Wednesday afternoon.

These are dramatic moves the like of which are rarely seen in government bonds.

Little choice for an ECB in a bind

But the ECB was in a real bind.

Had it shied away today from a half-point rise, which the market had been expecting earlier this week, it might have prompted some market participants to wonder what the ECB knew about the stability of the eurozone banking sector.

It would probably have sparked a big sell-off in European equities.

So ECB President Christine Lagarde and her colleagues on the bank's rate-setting governing council probably had little choice but to press ahead with the rate rise everyone had been expecting from it until earlier this week.

Instead, they chose to nod to the upheaval in banking stocks in the accompanying statement, adding: "The governing council is monitoring current market tensions closely and stands ready to respond as necessary to preserve price stability and financial stability in the euro area.

"The euro area banking sector is resilient, with strong capital and liquidity positions."

A dilemma to be faced by the US and UK

The dilemma faced by the ECB will be faced next week by both the US Federal Reserve and the Bank of England as they make their own policy decisions.

In some ways, their task is slightly easier than the one the ECB faced today, because both have been raising interest rates more rapidly than Mme Lagarde and her colleagues.

Yet in both countries, inflation - while slowing - remains well ahead of the Fed's and the Bank's target rates.

Under those circumstances one would expect the Fed to raise its main policy rate, Fed Funds, from the current 4.5-4.75% to 4.75-5% and the Bank to raise its main policy rate, Bank Rate, from 4% to 4.25%.

Both central banks, like the ECB, also have to weigh the battle against inflation against the risk of sparking a recession.

Jay Powell, the Fed chair, has been quite clear in the past that the Fed will not back off from sparking a recession if that is the price that needs to be paid for bringing inflation under control.

The Bank, on the other hand, may be persuaded to keep rates on hold and leave it for a few more weeks.
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