The European Central Bank (ECB) has increased its interest rates by half a point, in line with their previous plans, despite recent concerns about the health of banks that caused market unrest.

ECB President Christine Lagarde and her colleagues raised the main refinancing rate from 3% to 3.5%, marking the second consecutive half-point increase.

The ECB is the first major central bank to make an interest rate decision following the collapse of Silicon Valley Bank, and the U.S. Federal Reserve (Fed) and Bank of England (BoE) are set to make their decisions soon.

"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 ECB said in a statement. "The euro area banking sector is resilient, with strong capital and liquidity positions."

The collapse last week of Silicon Valley Bank in the United States has raised concerns about stress across the banking sector and sent shares into a dive, with Credit Suisse, long dogged by problems, at the center of the rout in Europe.

Now the ECB was set to reconcile its inflation-fighting credibility with the need to maintain financial stability in the face of overwhelmingly imported turmoil.

Complicating its task, the central bank for the 20 countries that use the euro currency was already committed to raising its deposit rate by 50 bps to 3% on Thursday.

"Unless the ECB sees the inflation outlook significantly different than one week ago, anything but a 50 basis point move would be a big mistake and hurt credibility," Danske Bank economist Piet Haines Christiansen said earlier.

Eurozone inflation was 8.5% in February, below its peaks of last autumn but way above the ECB’s 2% target, and the outlook is likely to remain grim.

Although forecasts for headline inflation will be cut due to the fall in energy prices, the new figures will continue to show price growth significantly above the target in 2024 and slightly over in 2025, a source with direct knowledge told Reuters.

Meanwhile, projections for underlying inflation, an indicator of the durability of price growth, are set to be raised, suggesting that disinflation will be protracted and monetary policy will have to remain tight for some time.

This outlook is so worrying that before the turmoil in the banking sector, many policymakers had advocated rate hikes continuing beyond March.

Cold feet?

Markets were nevertheless doubting the ECB’s resolve and have dialed back bets on the size of Thursday’s move and subsequent rate hikes. Money market pricing suggests that investors now see a 40-45% chance of a 50 bps increase, down from 100% last week but still above the 20% priced at one point on Wednesday.

The volatility comes as Credit Suisse said it would borrow up to $54 billion from the Swiss National Bank to shore up liquidity after its share price slump intensified fears about a global banking crisis.

Some argued that the banking stress was significant enough for the ECB to leave its guidance and dial back tightening plans.

"Current developments qualify as ‘extreme,’ in our view, justifying a reassessment of our ECB call," Barclays economist Silvia Ardagna said. "We assign a 20% probability to no hike, a 60% probability to a 25 bps hike, and a 20% probability to a 50 bps hike."

Even if the ECB goes ahead with the 50 bps hike, it is almost certain to move away from its current practice of signaling its next step and will leave the door open regarding the May meeting, even if a bias for higher rates remains.

Lagarde will almost certainly try to reassure investors about the health of the bloc’s banks, arguing that they are better capitalized, more profitable, and more liquid than during previous periods of turmoil.

But the ECB will likely stop short of offering specific measures to help banks, especially since it has just removed a subsidy from a critical liquidity facility to wean lenders off central bank cash.

Lagarde could signal that the ECB is ready to step in should contagion start impairing the health of eurozone lenders, thus preventing the ECB’s monetary policy from being deployed effectively.

"The ECB will be minded to stick to the separation principle: Gearing the monetary policy stance toward achieving the inflation aim; and using other tools to deal with financial stability," BNP Paribas said. "Interest rates are probably the wrong tool to address a liquidity problem."