By Jeremy Hawkins, Senior European Economist
June 7, 2022
At long last, it looks as if the ECB’s hawks are about to get their way. Thursday’s policy announcement is widely expected to pave the way for the first hike in the central bank’s key interest rates since July 2011. However, while a move as soon as this week is possible, it is still very unlikely. QE is not scheduled to end until next month at the earliest and (unless amended) forward guidance rules out a hike until after asset purchases have been completed. Nonetheless, a clear message forewarning financial markets of a planned change in policy in July would seem all but nailed on and there may well be some clues too about how the shift towards policy normalisation will be delivered. The central bank should also reaffirm that maturing QE assets will be reinvested so QT probably remains a while off yet.
Only a few months ago ECB President Lagarde was still maintaining that an increase in official rates in 2022 was unlikely. However, in recent weeks there has been a major reassessment of the Eurozone inflation picture. Indeed, since the last meeting in April there appears to have been a coordinated effort on the part of Governing Council (GC) members to get investors used to the idea that short-term borrowing costs will soon be going up. The only question now is by how much? At least some participants, such as Austrian central bank governor and mega-hawk Robert Holzmann, will be calling for a 50 basis point hike that would immediately lift the minus 0.50 percent deposit rate out of negative territory. However, traditionally the ECB moves only slowly and given what is still a highly uncertain economic outlook, for now a less aggressive 25 basis point hike seems more probable. Some members will also recall that the last time rates were raised the move had to be unwound just a few months later due to the onset of the global financial crisis. That said, should June’s flash HICP report (01 July) turn out especially strong, the central bank may have no choice but to go with the larger increase.
A policy tightening next month would reflect high, and increasingly broad-based, inflation. May’s flash HICP report put the Eurozone’s headline annual rate at some 8.1 percent, up from April’s final 7.4 percent and yet another all-time high. It was also (again) well above market expectations and fully 2.5 percentage points above the ECB’s peak forecast made in March. The narrow core rate was much more subdued at 3.8 percent, but this still constituted a sizeable 0.3 percentage point increase on the month and similarly, a new record high. Overall inflation has been above the 2 percent medium-term target every month since July 2021 and the underlying rate every month since last October and for some member countries prices would seem completely out of control. Within the Baltic group of states, headline rates now stand at a remarkable 20.1 percent in Estonia and 18.5 percent in Lithuania. Ominously too, annual Eurozone PPI inflation stands at an unprecedented 37.2 percent, underlining price pressures still in the pipeline.
The persistent overshoot of the target has clearly become a real issue for many on the GC, not least because it has prompted a significant increase in inflation expectations, a key input into ECB policy. According to the EU Commission, households’ view of future inflation climbed steadily from September 2020 through to a record high in March this year and, despite some slippage since, remained at historically very elevated levels in May. Similarly, expected selling prices in services and, in particular, manufacturing have also risen very sharply and posted all-time highs in April. The buoyancy of the consumer sector reading is particularly important as it raises the risk of larger pay rises. In Germany, the biggest union IG Metall, has already called for an 8.2 percent increase and the outcome here will set the benchmark for other industries. As it is, Germany is due to hike its minimum wage by 20 percent in October while French unions are demanding a rise of fully 20 percent. With unemployment across the region at a record low, workers are well placed to extract unusually large settlements – exactly the sort of second round impact from high inflation that the ECB wants to avoid.
Despite the central bank’s rebuttal, financial markets have thought the ECB to be behind the curve for some time and tightening speculation has become increasingly aggressive since April. A 25 basis point hike is currently more than priced in for next month and 3-month money rates are now seen around 1.0 percent at year-end, about 60 basis points above the expectation at the time of the last meeting. The ECB this week is unlikely to commit to anything more than a first increase in July but it could well signal that, subject to the economic data, it expects there will be more to come shortly after.
Even so, monetary tightening will come with the Eurozone real economy having only just recovered its pre-Covid level of output. GDP last quarter was a meagre 0.5 percent larger than in the fourth quarter of 2019 and within that, Germany was 0.9 percent smaller, Italy only unchanged and France just 0.3 percent larger. Indeed, total output for the region as a whole was around 4 percent below where it would have been if it had sustained its pre-Covid trend rate of growth. There is little hard data available on the effects of the Ukraine crisis and Covid-related lockdowns overseas on local economic activity but with Covid now much less of an issue domestically, Eurozone growth at least looks likely to be positive this quarter. That said, business and consumer confidence have suffered and the ongoing squeeze on real incomes from sharply higher prices should not be underestimated. Indeed, April retail sales were very weak. Moreover, the central bank has already warned that the housing market is likely to be hit by higher borrowing costs. A partial offset will come from the Next Generation EU and Recovery and Resilience Facility (RRF) package which the ECB expects will boost Eurozone GDP by around 0.5 percent in 2022 and 2023 but near-term prospects inevitably remain highly uncertain and the risks are clearly on the downside.
Higher interest rates will also pose additional risks to the stability of financial conditions which, as the ECB highlighted at the end of last month, have deteriorated since the outbreak of the war. Corporate spreads have widened, non-bank firms are facing low liquidity and the central bank is particularly worried about emerging market fragmentation. Spreads between peripheral Eurozone sovereign bonds and their German counterparts have widened significantly, posing an extra threat to economies already facing rising borrowing costs. On paper, the ECB could keep a lid on spreads by indicating its preparedness to buy large amounts of bonds as and when necessary. However, this would mean abandoning the capital key which limits would-be purchases for individual countries. Consequently, should spreads continue to increase, the ECB may announce a new tool specifically aimed at protecting the more vulnerable markets.
Since the April meeting, the economic data have shown no particular bias versus market expectations. Hence, Econoday’s economic consensus divergence index (ECDI) has registered both positive and negative readings, reflecting upside and downside surprises. Essentially this indicates that the broader economic picture has evolved much as anticipated. Nonetheless, the much steeper than expected drop in April retail sales that dragged the inflation-adjusted ECDI (ECDI-P) back below zero last week could yet be a warning sign that the Ukraine fallout will ultimately be more damaging to economic activity than currently discounted.
In sum, Thursday’s announcement will be much more important for what it has to say about the ECB’s policy intentions for July and beyond, rather than what it plans for this month. It seems all but certain that interest rates are going up, but probably not just yet. The nominal neutral rate has been estimated to be between 1 and 2 percent, but, in true ECB fashion, getting there will take time.