European flags are seen in front of the European Central Bank (ECB) building, in Frankfurt, Germany, July 21, 2022. REUTERS/Wolfgang Rattay

LONDON, July 21 (Reuters Breakingviews) - The European Central Bank has simultaneously darkened the euro zone’s economic prospects and created a tool that may help it deal with the consequences. President Christine Lagarde on Thursday announced a surprise 0.5% interest rate hike while unveiling a new instrument to defend a country facing a speculative attack. The effects of the first decision are clear; the consequences of the second are more elusive.

The ECB’s first increase in interest rates since 2011 was double the 0.25% hike the central bank had announced a month ago. This was the price the hawkish wing of its governing council extracted for agreeing to the creation of the “Transmission Protection Instrument” – a commitment to buy the bonds of countries facing “unwarranted, disorderly market dynamics”.

The criteria for triggering the tool are so loose that any euro zone member could qualify. Lagarde fended off ECB hardliners, who wanted countries benefitting from the scheme to pledge specific economic policies under the supervision of the European Stability Mechanism, the euro zone’s bailout fund. The TPI’s flexibility and undemanding terms give Lagarde and her fellow governors the freedom to decide when to let financial markets impose discipline on member states, and when to push back.

The new TPI’s potency will depend on whether it can be activated swiftly. This will not be clear for a while. The ECB will only consider using it after reinvesting the proceeds of maturing bonds from the 1.7 trillion euro bond-buying programme it unleashed during the Covid-19 pandemic.

Investors will doubtless test the limits of the ECB’s resolve, probably starting with Italy. Yields on the country’s 10-year government bonds have risen to 3.5% from 1.2% at the beginning of the year. The extra yield investors demand to hold Italian bonds over the equivalent German securities widened to more than 2.2% on Thursday, as markets reacted to the resignation of Prime Minister Mario Draghi.

Lagarde said that she would rather not use the TPI. However, while raising rates will have little immediate impact on inflation, it may bring forward the upcoming economic slowdown. In this sense the ECB is playing with economic fire, while simultaneously unspooling its firehose.

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)

The European Central Bank on July 21 announced that it would raise its key interest rate by 0.50% to zero, ending eight years of negative rates.

President Christine Lagarde also announced the creation of a new “Transmission Protection Instrument” which allows the central bank to purchase euro zone government bonds to avoid “unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy”.

The ECB said its 25-strong governing council would decide to launch the programme on a case-by-case basis, based on a series of economic policy criteria.

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