By Jeremy Hawkins, Senior European Economist
July 18, 2022
The long-awaited first interest rate hike of the ECB’s new policy cycle should be delivered on Thursday. The June statement indicated that the central bank was planning to lift official rates by 25 basis points at its July meeting and to follow that by at least a further 25 basis points in September. This would put the key deposit rate at minus 0.25 percent this week and zero percent at the start of the fourth quarter. However, the ECB will also confirm that while the asset purchase programme (APP) was finally terminated on 1 July, maturing assets from both it and the pandemic emergency purchase programme (PEPP) which ended in March will continue to be reinvested to ensure that there is no quantitative tightening (QT).
A number of Governing Council (GC) members clearly wanted to raise rates in June but it seems that the majority thought a more measured approach to start the tightening process would come as less of a shock to the financial system. Even so, since then, inflation has climbed still higher and new research by the ECB has shown that it is not just import costs on the rise but domestic price pressures too. Consequently, at least some of those who sought a 25 basis point increase in rates last month will now be pushing for 50 basis on Thursday – and at least the same again next time. Indeed, in the wake of June’s HICP report and notwithstanding Chief Economist Lane’s insistence that the smaller change is already agreed, the question now is whether or not a 50 basis point hike could come as soon as this week.
Financial markets will also be looking for information on how the ECB plans to deal with the upside pressure on yield spreads caused by rising short-term interest rates. In such an environment, bonds in the more highly indebted countries inevitably suffer disproportionately, destabilising the policy transmission mechanism and potentially even leading to euro break-up risks. To this end, apart from indicating a willingness to be flexible over PEPP reinvestments, investors were unimpressed when the June policy announcement failed to address the fragmentation issue. As a result, the gap between 10-year German bunds and Italian BTPs increased sharply to 240 basis points, the most since May 2020. Indeed, the BTP yield temporarily climbed above 4 percent for the first time since 2014.
Widening spreads prompted the ECB to announce that it is working on an anti-fragmentation tool (apparently called the Transmission Protection Mechanism) and this has stoked speculation that the central bank does not want to see the spread much above 200 basis points. As of 1 July, the bank started to use some of the proceeds received from maturing German, French and Dutch debt to buy bonds from Italy, Spain, Portugal and Greece. However, it will take more than simple reinvestment to convince markets of the ECB’s commitment to euro stability and the Bundesbank has already made clear its lack of appetite to intervene to secure what it might see as artificially tight spreads. Complicating matters further, any intervention will have to be sterilised or the balance sheet will start expanding again.
Inflation developments since June’s meeting have added to pressure for an interest rate rise but have also offered some hope that inflation may be close to peaking. On the gloomy side, the headline rate again beat expectations last month, climbing fully 0.5 percentage points to 8.6 percent, yet another record high. At the same, the core gauge excluding just energy and unprocessed food gained 0.2 percentage points to 4.6 percent, similarly a new all-time peak. However, the narrow core rate surprisingly dipped a tick to 3.7 percent. In other words, there was something for the hawks and doves alike. Still, the bottom line is that the trend remains in the wrong direction and the ECB will have noted with alarm its increasing impact on inflation expectations. Two recent surveys found German households now expecting national inflation to average fully 5.3 percent over the next five years and their French counterparts, 5.0 percent (up from 3 percent at the end of 2021). Such readings will not go down at all well and will not be seen as consistent with achieving the 2 percent HICP target.
In her post-meeting address last month, President Lagarde indicated that inflation developments would be key to determining the size of September’s rate hike. Indeed, she intimated that unless the inflation outlook improved by the time of the next forecasting round, a tightening in excess of 25 basis points would be more than likely. The 2-year ahead HICP inflation forecast currently stands at 2.1 percent and so anything above or even just matching this mark looks likely to trigger at least a 50 basis point move. The updated forecast is due to be released on the same day as the September policy announcement (8 September).
Even so, the doves will be wary of tightening too rapidly. The Eurozone economy is slowing and the outlook is crucially dependent upon what Russia decides to do with its energy exports. The region receives around a quarter of its energy from natural gas, with Russia accounting for about one-third of the bloc’s imports (and some 55 percent of German fuel purchases before the war in Ukraine began). The ECB’s June forecasts essentially assumed no major deterioration in supplies but gas flows through the key Nord Stream 1 pipeline under the Baltic Sea have fallen sharply and were (supposedly just temporarily) suspended for maintenance work on 10 July. Hit by soaring fuel and other prices, retail sales volumes have not expanded since December and, with spending on food, drink and tobacco especially weak, look very likely to subtract from second quarter GDP growth. According to the June PMI, private sector business activity is now rising at its slowest pace in sixteen months and even the traditional healthy surplus on foreign trade has been replaced by a steadily expanding deficit since last October. Against this backdrop, both business and, notably consumer, confidence have deteriorated significantly.
That said, since the June meeting, Econoday’s economic consensus divergence index (ECDI) reveals a mixed performance by the forecasters with the data surprising on both the upside and the downside, in line with the general pattern seen over much of the year to date. The most recent data have typically been rather stronger than expected which should help to ease worries about a possible recession but not to the extent that would offer any real support for anything more than a 25 basis point hike in interest rates on Thursday.
In sum, investors will be focussed on two aspects of Thursday’s announcement: the size of the seemingly inevitable hike in key interest rates and the details of any new anti-fragmentation tool. Being the ECB, securing agreement on either will not be simple so the risks are probably biased towards disappointment.