Digital Zeitgeist – The Final Countdown: Five Key Questions for the European Central Bank
As the financial world turns its eyes towards the European Central Bank (ECB), an imminent quarter-percentage-point rate hike appears to be a ‘fait accompli’ for the coming Thursday. However, the more burning issue for markets is deciphering how many further hikes will follow. This development comes at a time when the Eurozone’s economy grapples with recession and the area’s inflation rates have dipped quicker than forecasted in May.
The ECB’s swift cycle of rate hikes, the fastest in its 25-year existence, is likely to draw to a close soon. This trajectory is buoyed by a more hopeful outlook, according to Frederik Ducrozet, Pictet Wealth Management’s Head of Macroeconomic Research. He asserts, “Everything is finally going in the right direction for the ECB.”
- The Case for a Smaller Hike
There is a consensus amongst observers that the ECB is set to adopt a less aggressive approach, leaning towards a modest rate hike. This expectation follows its renouncement of bold moves in May. All eyes will be on the ECB chief Christine Lagarde and her cues about the policy outlook.
Lagarde is likely to reiterate the necessity for rates to escalate to levels sufficient to restrain inflation. However, she must tread the delicate line of maintaining the ECB’s flexibility, without appearing excessively dovish. Mike Kelly, Head of Multi-asset at PineBridge Investments, emphasised this point, cautioning that “The main issue for the ECB is not to get backed into a pause corner by the markets the way the Fed was,” alluding to the U.S. central bank.
- The Response to Slowing Inflation
The markets applauded the Euro area’s inflation drop in May, exceeding expectations. Crucially, the ECB will be relieved to witness a deceleration in core inflation. This metric omits volatile prices associated with energy, food, alcohol, and tobacco.
However, it’s important to note that at 5.3%, core inflation remains near a record high. Furthermore, wage growth is double the rate that aligns with the ECB’s inflation target. Chris Attfield, HSBC rate strategist, regards this positively, stating, “The ECB will react to those numbers by saying that monetary policy is working, their messaging is working, and they must stay the course.”
- The Impending Pause
It’s the market’s consensus that the ECB will have concluded its cycle of hikes by September, following an additional 25 bps hike, most likely in July. Several policymakers have essentially pre-committed to a move then.
Even though inflation remains high, it is slowing down. There’s also been a noticeable decline in loan demand, with lending standards hardening at a historically rapid pace.
Flavio Carpenzano, Investment Director at Capital Group, suggests that a flagging European economy may hinder any further rate increases. Nevertheless, advocates for rate hikes, such as Germany’s Joachim Nagel, continue to keep further increases beyond the summer on the agenda.
- The ECB’s Staff Projections
The Eurozone was plunged into a recession in the first quarter, primarily driven by Germany, the bloc’s economic powerhouse. This reality has defied many expectations, indicating that growth forecasts could potentially be revised downwards.
A pertinent question centres on whether the ECB will modify its 2.1% inflation forecast for 2025 to meet its 2% target. In more stable times, such a revision would typically pave the way for the ECB to halt hikes. Piet Christiansen, Danske Bank’s Chief Analyst, offers his perspective, “If that comes out at 2%, I think markets will treat this as a risk that the ECB has then delivered its final hike (on Thursday).”
- The ECB’s Actions in Light of the Fed’s Decisions
It is widely anticipated that the Federal Reserve will maintain its rate status quo in June, before unveiling a final rate hike in July.
Under ordinary circumstances, a pause by the Federal Reserve would present a conundrum for the ECB. However, this cycle is atypical because the ECB initiated its cycle later and is expected to wrap up shortly. Frederik Ducrozet from Pictet speculates that a rally in the Euro that curbs activity might be welcomed by the ECB in light of high inflation.
There are, however, potential headwinds to consider. Traders are already pricing in rate cuts next year, leading to resistance from rate setters. If the Federal Reserve opts to cut rates due to a looming recession, the ECB may need to reassess its trajectory as the Eurozone’s economy braces for impact.
A Devil’s Advocate Perspective: The Conclusion
While the above arguments present a compelling case for the ECB to adopt a cautious approach towards further rate hikes, it’s worth exploring a few contrary viewpoints.
Firstly, while the European economy is currently in recession and inflation rates are slowing, these are inherently volatile and could rebound unexpectedly. Therefore, the ECB should not be too hasty to put a halt on rate hikes. Maintaining the option to increase rates could provide a crucial buffer against any unforeseen shocks.
Secondly, while the ECB’s communication strategy has been effective so far, the delicate balance of controlling inflation without curtailing growth could be upset by overly dovish statements. Ensuring a balanced communication strategy is vital to prevent the markets from boxing the ECB into a corner.
Lastly, the ECB’s response to the Federal Reserve’s actions should be guided by the needs of the European economy rather than the actions of its American counterpart. While a pause by the Fed would typically present a problem for the ECB, the unique circumstances of the current cycle mean that the ECB should be guided by internal factors, rather than external pressures.
Ultimately, the future actions of the ECB should be determined by an evaluation of multiple factors including core inflation, wage growth, economic forecasts, and external influences. The answer to whether the ECB’s rate hike cycle is indeed entering its ‘final countdown’ remains to be seen. Only time and the ever-evolving economic landscape will tell.
Sources:
[1] Reuters interview with Frederik Ducrozet, Pictet Wealth Management’s Head of Macroeconomic Research [2] Mike Kelly, PineBridge Investments commentary on ECB and Federal Reserve relations [3] Chris Attfield, HSBC rate strategist’s remarks on ECB’s policy effectiveness [4] Flavio Carpenzano, Investment Director at Capital Group, on the constraints of the European economy [5] Remarks by Germany’s Joachim Nagel on the possibility of further rate hikes [6] Danske Bank’s Chief Analyst Piet Christiansen’s assessment of the ECB’s inflation forecast [7] Market trader sentiment regarding potential rate cuts, according to financial market data [8] Analysis on the impact of the ECB’s communication strategy [9] Observations on the unique rate hike cycle of the ECB compared to the Federal Reserve.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of GPM-Invest or any other organisations mentioned. The information provided is based on contemporary sourced digital content and does not constitute financial or investment advice. Readers are encouraged to conduct further research and analysis before making any investment decisions.