4 MAY, 2023
By Constanza Ramos
The ECB has done it again: it has raised interest rates by 25 basis points. This is a somewhat lower increase than in previous meetings, as the last three had been 50 basis points. The price of money now stands at 3.75%.
The European Central Bank has justified its decision to go ahead with rate hikes by arguing that inflationary pressures remain high. It acknowledges that inflation has eased in recent months, but notes that underlying pressures “remain strong”.
The European Central Bank has lived up to expectations, announcing a 0.25% interest rate hike, leaving the deposit rate at 3.25%. But their comment on their inflation estimates was very striking: they expect inflation to be too high for too long.
Moreover, the ECB acknowledges that inflation is still at risk of an upside surprise. This comment suggests that the ECB will be more restrictive for longer. In fact, since the start of last year’s rate hikes, the central bank has always been more restrictive than the market expected. However, the ECB is now entering a difficult environment, where it will have to navigate between slowing growth, a bank under scrutiny on its deposit base after the Credit Suisse earthquake, and inflation still too high and far from its 2% target.
Lagarde has acknowledged that they see divergences in the economy, with the manufacturing sector suffering, but the services sector still strong. This strength may have influenced the announcement that they will no longer reinvest the asset purchase programme (APP) – such an announcement was not expected at this meeting – a sign that we are in a QT process. Although, to compensate, they do not give estimates of future rate hikes, they clearly say that the rate hike cycle is not over in Europe, the journey continues regardless of what the Fed does, but they have been unwilling to give guidance on how much more they will raise rates. The latter is what has put some downward pressure on 2-year bond yields and the euro.
The forward-looking elements of the statement point to the end of the upward path, with two further 25 basis point hikes. Together with the phasing out of the Asset Purchase Programme, which will end in July.
The light at the end of the tunnel of the end of hikes should be favorable for bond markets in general. Although the end of reinvestments under the asset purchase programme is expected to put upward pressure on yields of the sovereign issuers that have benefited most from the program, i.e. the so-called peripheral countries, especially as they have so far shown no signs of stress from quantitative tightening.
The European Central Bank did not disappoint market expectations today. After yesterday’s decision by the Federal Reserve, it slowed its pace and raised all official interest rates by only 25 basis points. The tightening of monetary policy is certainly starting to take effect. Financing conditions are deteriorating and credit demand is likely to decline further in the coming months. So far, however, the effects have not yet reached the real economy. But as long as the economy remains relatively strong and, above all, the tight labour market suggests further strong wage increases, the ECB cannot stand on the sidelines, because the inflation rate and the underlying price trend are, and will remain, too high and too strong for that. The ECB has made this unequivocally clear. The ECB has not yet reached the end of its interest rate hikes. President Lagarde spoke in this context of a journey: “we are not there yet”. We expect more rate hikes in the coming months.
At its May meeting, the ECB raised rates by 25 basis points, in line with market prices, reducing the pace of hikes to the smallest increase since the start of the hiking cycle in July 2022. Given some cooling, albeit very moderate, in core inflation in March and the rapid tightening of bank lending conditions, as evidenced by the ECB’s latest bank lending survey, this decision appears to be in line with economic developments. The monetary policy statement was moderate in tone, noting that the tightening of monetary policy is already being transmitted “strongly” to financial and monetary conditions.
We continue to believe that the degree of policy tightening implemented by the ECB to date is already sufficient to trigger a recession. The effect of tighter policy is becoming more evident in the US, where the Fed has signalled a possible pause at its May meeting, largely because it began its hiking cycle four months earlier than the ECB. Given the delays in the transmission mechanism, the euro area’s real economy has yet to feel the impact. Even without further acute strains in the European banking system, tight credit conditions are here to stay, ultimately leading to credit contraction and recession. Renewed banking strains in the US add another layer of uncertainty to an already complex outlook. Fundamentally, with the Fed on pause, the policy divergence between the US and the European economic space cannot go very far. We continue to insist that the ECB is very likely already in an area of policy error that will ultimately require a rapid course correction in the coming months.