Most economists, fixed income analysts and investment strategists agree that the European Central Bank on Thursday will raise interest rates. The key question is: will the hawks get their 75 basis point hike? Or will doves be heard with a 50 point increase? Some still question if hiking rates into a recession is the right thing to do.
Speaking at the Federal Reserve’s Jackson Hole conference two weeks ago, ECB executive board member Isabel Schnabel echoed Fed chief Jerome Powell by referring to the 1970s, when central banks worldwide took too long to acknowledge higher rates were needed to bring spiralling costs of living under control.
“Regaining and preserving trust requires us to bring inflation back to target quickly,” said Schnabel, who spoke in the absence of ECB president Christine Lagarde. “The longer inflation stays high, the greater the risk that the public will lose confidence.”
Her comments, together with fresh data on persistently high inflation in the eurozone, encouraged expectations of a bigger than anticipated rate hike on 8 September, 75 bps instead of 50 bps. Yet not all economists agree this is the best scenario for the eurozone economy, which is about to enter into a severe recession due to rising energy prices while the euro has fallen to below parity against the dollar.
ECB risks a policy mistake
“A 75 bps hike may have the opposite effect,” tweeted Robin Brooks, chief economist at the Institute of International Finance in Washington. “It will embolden market chatter that the ECB is making a policy mistake, as it’s hiking into a deep recession. Best way to support Euro is NOT to hike.”
The ECB appears to be stuck between a rock and a hard place, and is damned if they raise and damned if they don’t. That scenario is likely to become more pronounced in the coming months. If governments try to protect consumers from higher energy prices with fiscal stimulation, there is a risk that fiscal and monetary policies will diverge.
“Any attempts from governments to shield consumers from higher energy prices could mean that fiscal and monetary policy are pulling in opposing directions from an inflationary perspective,” noted Vincent Juvyns, global market strategist at JP Morgan Asset Management, who sees a 75 bps hike coming on Thursday. “So if further fiscal stimulus were to prevent a recession, it would increase the risk that the ECB would have to continue raising rates into 2023.”
Fiscal support affects monetary policy
At Pictet Wealth Management, head of macroeconomic research Frederic Ducrozet noted that eurozone fiscal stimuli so far announced this year is exceeding 2 percent of GDP. Germany now stands out as one of the most fiscally active member state, although fresh initiatives are to be expected in other countries in coming weeks. “The final impact on activity and inflation remains uncertain because of timing and implementation issues,” he said.
“Central banks should welcome any initiative that help reduce the burden on the most vulnerable households and energy-intensive companies,” Ducrozet said in a note. “Fresh fiscal support should be consistent with a tighter monetary stance, or at least political cover for central banks to keep hiking rates.”
Pictet does not believe there will be a dovish surprise on Thursday. “Expectations have been more carefully recalibrated and the rationale for a 75bp hike was laid out, the ECB is unlikely to surprise on the dovish side especially as the currency remains under pressure, adding to the imported inflation problem… For now, risks are tilted towards a faster front-loading.”
Berenberg not convinced on 75 bps
Following Schabel’s speech, markets expect the ECB will lift its benchmark rates from 0 to about 2 percent in the coming months. German private bank Berenberg, considering the impact of a further rapid rise in bond yields coupled with widening spreads, said there is a 40 percent chance of a 75 bps hike on Thursday.
A strong hike “may raise the risk that the ECB may have to use its new ‘transmission protection instrument’ (TPI) to shield Italy from disruptive market moves shortly,” Berenberg’s chief economist Holger Schmieding wrote. “A discussion about the possible use of the TPI could be highly controversial. The majority on the ECB council may prefer to not get into such a situation in the first place. This may be one of various arguments that point to a 50bp rate hike, in line with the call of ECB chief economist Philip Lane for a “steady pace” in normalising rate policy.”
Konstantin Veit, Portfolio Manager at Pimco, told clients that he expects the ECB will raise 50 bps on Thursday and flag similar increases for its October and December meetings. “We think the [Governing Council] will make clear that a neutral policy setting might not be appropriate in all conditions, and expect a transition towards moving in 25 basis point increments next year as the hiking cycle pivots from policy normalisation to policy tightening.”
Powerful step may not be justified
Katharine Neiss, chief European economist at PGIM Fixed Income, notes the market anticipates a 75 bps increase, although she questions if such a powerful step is justified.
“The risks of persistently higher inflation on the long term are becoming embedded in the economy, which makes the painful adjustment to the energy shock even more difficult. The ECB will try anything to prevent that this difficult situation from deteriorating,” Neiss said. There seem to be no easy answers to the shocks that the eurozone is being confronted with.”
AXA Group Chief Economist Gilles Moëc told clients a 75 bps is the firm’s new baseline scenario following the release of the latest eurozone inflation data. “They would ‘rip the band aid’ and bring the policy rate faster in neutral territory,” he said.