Eurozone interest rates will rise further in the near future as evidence grows that inflation has become entrenched, leaving the European Central Bank no option but to continue to hike its policy rates. At Ethenea, ECB watchers believe official deposit rates could more than double from current levels.
Most outlooks for Thursday’s ECB meeting point to a persistent hawkish tone from Frankfurt. PGIM Fixed Income, one of the world’s biggest bond investors managing some 759 billion, believes eurozone rates “may well need to rise by significantly more than the market currently expects” if the economy continues to surprise on the upside, a view also shared by Monex Europe.
Luxembourg’s BLI however believes that even current market expectations of an additional 125 basis points in ECB rate hikes are “ambitious”. State Street Global Advisors does not believe the ECB will take its deposit rate above 3.5 percent from its current level of 2 percent.
Although eurozone consumer price inflation fell for two consecutive months from a 10.6 percent peak in October, core inflation - the cost of goods and services excluding food and energy - continued to rise in November and December. It’s a clear sign inflation has become entrenched. It means the ECB needs to make further efforts, said Ethenea portfolio manager Volker Schmidt in a note.
‘Asset cushions’
Massive eurozone fiscal policy support contributes to higher costs of living. Covid-19 aid packages have boosted assets of private households. Capitalisation of many companies is better than before the crisis. “The support payments to cope with the energy price explosion mean that these asset cushions will be maintained,” Schmidt said, adding the EU’s intention to counter the US government’s infrastructure programme with a corresponding counterpart will also press prices up.
Against this background, the ECB can only remain hawkish, he said. “This is building up inflationary potential, which the central bank should counterbalance as soon as possible in the form of even more significant interest rate hikes. Raising the deposit rate from the current 2 percent to 3 percent will not be sufficient. 4, 5 or even 6 percent should be the target, accompanied by a timely reduction in ECB’s bond holdings.”
Katharine Neiss, chief European economist at PGIM Fixed Income, said the ECB is on a different trajectory than the Federal Reserve, whose policy rates are getting close to peak levels. Consensus for the first quarter: the ECB will raise rates by 100 basis points with two back-to-back hikes, this Thursday and then again on 16 March.
“Only thereafter does the market expect the pace of rate hikes to slow, with the deposit facility rate peaking above 3 percent by the end of this year,” Neiss said.
Financial stability risks
PGIM sees risks emerging. Fundamentals around tight global energy supply and an escalation in the Russia-Ukraine conflict have not gone away, even though recent economic data has been better than expected. “Further tight monetary policy could tip the economy into recession, and possibly trigger financial stability risks in high-debt euro area economies,” Neiss wrote.
Italy’s high level of government debt will remain a factor influencing ECB policy, said State Street’s head of macro policy research Elliot Hentov, who still believes the eurozone will enter a small recession.
Current market estimates indicate the ECB deposit rate will end up at around 3.25 percent, which would correspond to a further tightening of 125 basis points. “Such a big interest rate hike looks ambitious, given the likelihood of mounting signs of recession in the first half of the year and the growing risk of fragmentation in the eurozone government bond market,” Luxembourg’s BLI told clients.
Downshift
Simon Harvey, head of FX analysis at Monex Europe, expects both the ECB and Bank of England on Thursday will signal a downshift to 50 basis point increase, following earlier 75 point hikes. The central banks’ forward guidance will shape market reaction. The BOE is expected to cast a bleak economic projection, while the ECB’s challenge is more difficult.
“The recent string of stronger than expected activity data suggests that the ECB may need to cast a more hawkish tone,” Harvey said. “Risks to headline inflation are likely to migrate towards H2 2023’s inflation projection when Europe competes with a striving Chinese economy to refill its energy inventories.”
The Federal Reserve will discuss US interest rates Wednesday evening around 20 CET. The ECB’s decision is due at 14:15 CET on Thursday, to be followed by a press conference with president Christine Lagarde.
Related articles on Investment Officer Luxembourg:
- The ECB should learn from the Fed
- ECB: Banks lead financing of carbon-intensive activities
- Markets ‘vulnerable to hawkish surprises’ as Fed, ECB meet