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The ECB has raised all three of its key policy rates by 25 basis points in line with both market and economist consensus. This latest hike now leaves the Deposit Facility rate at 3.25%, with the interest rate on the main refinancing operations and the interest rates on the marginal lending facility rising to 3.75% and 4.00% respectively.
Whilst the debate in weeks leading up to this decision had been around whether the ECB should continue with its series of 50bp increases in policy rates, the release of CPI data over the past week tipped the balance of expectations firmly towards slowing the pace of hiking. With eurozone inflation rising only modestly in the latest release from 6.9% to 7.0% due to idiosyncratic factors, and core inflation decreasing by 0.1%, it appears as though the peak for inflation may now be in. Despite this, the statement released by the ECB alongside this latest decision recognised that “the inflation outlook continues to be too high for too long”, and that “headline inflation has declined over recent months, but underlying price pressures remain strong”. Whilst this was an attempt to indicate that more tightening is necessary, the clear signal to markets from the reduction in hike size was that the end of this hiking cycle is now coming into view.
The end of the hiking cycle is coming into view
With the ECB stepping down the pace of hiking and eurozone headline inflation likely to have peaked, the thoughts of markets will inevitably turn to the terminal level for eurozone interest rates, and to how long policy could, or indeed should, keep them there. Clarity on this point was not to be found in the press release, with the text reading simply that “policy rates will be brought to levels sufficiently restrictive to achieve a timely return of inflation to the 2% medium-term target and will be kept at those levels for as long as necessary”, and stressing the data dependence of ECB decision making. Alongside a decision to halt reinvestment through the APP, this represented a modestly hawkish shift in tone, though it provided little detail in practice for markets.
The press conference that followed the policy rate announcement did little to add transparency for markets, although President Lagarde did retain a hawkish tone.
“We are not pausing, that is very clear” became something of a theme in the early part of the press conference, attempting to draw a line between the outlook for the ECB and their American counterparts, whose guidance less than 24 hours earlier was widely interpreted as signalling a Fed pause. Beyond this commitment to continue raising rates for the time being, further detail was sorely lacking. Despite being repeatedly pushed to offer more information on how high rates could go, Lagarde avoided the questions, suggesting that “it is not so much the destination that matters, but the journey”, and that whilst she does not “have a magic number on what constitutes sufficiently restrictive”, “we will know it when we get there”. She did not however push back strongly on suggestions that another 50bp of hiking would be appropriate, and whilst failing to confirm this as correct, it was suggestive that this figure may well be in the right ballpark in the ECB’s thinking. Some of this reticence in committing to a policy path appears to be a result of uncertainty around the extent of tightening of financial conditions. Certainly Lagarde’s comments implied this, highlighting the uncertain degree of passthrough from policy and a tightening in credit conditions from financial stability concerns as risks to the outlook for the ECB.
One interesting point, brought up by President Lagarde in her initial remarks and entirely unprompted, were comments on fiscal policy, an unusual intervention for a central banker.
That these followed similar comments by François Villeroy de Galhau in the lead up to this latest meeting was notable. Specifically, they have now both called out the impact of fiscal policy in offsetting monetary tightening, suggesting that greater public spending would ultimately result in higher ECB policy rates. These interventions follow German public sector wage negotiations that resulted in an agreement to increase wages by almost 6% a year for the next two years on average, and set the bar high for other pay agreements that are likely to follow, a point alluded to by Lagarde in her press conference. Meanwhile in France, protests continue over the raising of the state pension age, suggesting the government will find it difficult to negotiate the below inflation increases in wages needed to sustainably bring inflation back to target. This intervention by Lagarde suggests a level of discomfort at the ECB, with the potential for rising government spending on wages to produce stickier than anticipated core inflation, explaining some of the President’s hawkish bias.
Actions speak louder than words: Despite Lagarde’s hawkish tone, markets remain unconvinced
Ultimately, it is clear that the ECB is now in the home stretch when it comes to monetary tightening, despite Lagarde’s attempt to steer markets away from this narrative.
Therefore, despite firm expectations heading into the announcement for the ECB to step down rate hikes to 25bp, and communications from President Lagarde being broadly as expected, front end euro government bonds broadly sold off on today’s news. This dynamic was reflected in euro price action as well, with the single currency dropping six tenths between the initial announcement and the end of the press conference, with markets failing to buy into Lagarde’s hawkish tone, given the lack of detail provided. These market dynamics highlight the difficulty of the job facing the ECB in managing market expectations as it approaches the end of its hiking cycle. Whilst the tightness of credit conditions will continue to be a source of significant uncertainty, we see today’s announcement as in line with our call for a further two rate hikes from the ECB. If so, this will close rate differentials to other central banks, and likely provide some upside to the euro against other major currencies over coming weeks, but with downside risks if the ECB does eventually undershoot market expectations.
Authors:
Nick Rees, FX Market Analyst