Lagarde says: ECB may have to restrict growth to control inflation

The European Central Bank will keep raising interest rates and may even need to restrict economic activity to tame inflation, ECB President Christine Lagarde said on Friday, singling out rates as the bank's key instrument over balance sheet reduction.

The ECB has raised rates by an unprecedented 200 basis points since July to tackle inflation, and said that more policy tightening is coming via rate hikes and the reduction of its 5 trillion euro ($5.2 trillion) debt holding.

"We expect to raise rates further and withdrawing accommodation may not be enough," Lagarde said in a speech at a conference. "Interest rates are, and will remain, the main tool for adjusting our policy stance," she said.

"Acknowledging that interest rates remain the most effective tool for shaping our policy stance, it is appropriate that the balance sheet is normalised in a measured and predictable way."

At 1.5%, the ECB's deposit rate is not far from the so-called neutral rate, where the bank is neither stimulating nor holding back growth.

Most estimates of the neutral rate are between 1.5% and 2%, suggesting that after an expected December hike "accommodation" will have been removed.

The problem is that inflation, running at 10.6%, is far above the ECB's 2% target and even a recession, now almost certain over the winter months, is unlikely to ease price pressures enough to let the ECB step off the brakes.

Investors are now split between pricing a 50 and 75 basis-point hike in December after back-to-back 75 basis point moves, and see the reduction of bond holdings, also known as quantitative tightening, starting in the first half of 2023.

The ECB will outline plans for balance sheet reduction in December and the process is expected to start with the bank allowing some, but not all, bonds to expire. "The ECB will ensure that a phase of high inflation does not feed into inflation expectations, allowing too-high inflation to become entrenched," Lagarde said.

Separately, a top European Central Bank official said, the recent collapse of a major cryptocurrency exchange platform that has sent shockwaves through the largely unregulated sector is "not a surprise".

The popular FTX platform filed for bankruptcy in the United States last week with a reported $8-billion hole in its finances, sparking a confidence crisis among investors and dragging down key currencies like bitcoin.

ECB vice-president Luis de Guindos said the FTX failure "is not a surprise", given the "vulnerabilities and the weaknesses" of the burgeoning crypto industry. But he said the turmoil remained confined to the crypto asset space and had not yet had any spillover effects. "So far it did not have implications in terms of financial stability for the broader financial markets," de Guindos told reporters in a call.

But he acknowledged there were "obscure channels" between "the crypto space and the rest of the financial market", which the ECB was already watching "carefully". Central banks around the world have long been critical of the volatile world of cryptocurrencies, which are issued privately and are often not backed by any tangible assets or public authority.

ECB chief Christine Lagarde in May said cryptocurrencies were "based on nothing" and "worth nothing". The spectacular failure of the FTX platform has revived memories of the downfall of the Lehman Brothers bank in 2008, which amplified the global financial crisis. The crypto industry was already battered earlier this year by the collapse of virtual currency terra, which was supposed to be pegged to the US dollar, and of cryptocurrency investment platform Celsius.