When it comes to monetary policy decisions and outlook, sometimes central bankers choose to be specific and at other times vague. In the earlier phases of the hiking cycle, this involved much clearer signals of further increases. Now, with the emphasis on data dependency, it appears some central bankers are going out of their way to say a lot, but mean very little.
A case in point was the decision by the European Central Bank (ECB) to raise rates by 0.25% earlier this week, taking the deposit rate to 4%. Prior to the announcement, comments from some voting members showed a preference to keep rates on hold. Consequently, this was seen by investors as a finely balanced decision.
Given this backdrop, a lot of focus was concentrated on the messaging around it to ascertain whether this was a “dovish hike” or opening the door to further increases in the future. In that regard, the prepared statement said the following: “Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target. The Governing Council’s future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary.”
This lengthy statement is worded such that it’s possible to draw different conclusions. Looking at the revisions to inflation and growth help us understand their thinking. Inflation was revised up by 0.2% for this year and more importantly to 3.2% next year versus the 3% estimated. In 2025, it is a touch above their 2% target. On the other hand, growth was revised down to 0.7% (1% prior) this year and next year growth was revised down by a material 0.5% to just 1%. Combined, these paint a much more stagflationary backdrop than previously thought.
So for investors, which revision matters more and what does that mean for rates in the Eurozone?
Clearly the ECB found it difficult to ignore the forecast showing inflation above 3% next year which helped cement the decision for some members to hike rates this month rather than pause. Furthermore, core inflation in the Eurozone has been 5% or higher for nearly a year now raising concerns of its stickiness. To that effect, the statement inclusion of “sufficiently restrictive” perhaps leaves the door open for more hikes.
However, with its latest increase, the ECB has raised rates by a cumulative 4.5%. For a currency bloc that operated under zero or negative interest for a decade, this leaves it exposed to unintended consequences. The ECB also commented on its monetary policy transmission and concluded it’s both effective and efficient. For companies that are refinancing in this higher interest rate world, this represents an enormous increase in the cost of borrowing and will likely lead to less capital expenditure. Weaker businesses that cannot afford these higher costs may face bankruptcy, which in turn will have consequences on the labour market. Recent surveys are already showing a meaningful slowdown in both the manufacturing and service sectors, and there are questions on whether the ECB’s revised growth projections are still too optimistic.
Taking it all together, the above message reads to us that the ECB expects to have completed its rate hiking cycle. It is becoming increasingly concerned about growth, while the full effects of prior monetary policy increases are yet to feed through. Some signs of disinflationary pressures are coming through, but the ECB are not yet prepared to tell investors that it is indeed done with its rate hiking cycle if core inflation remain at elevated levels and the economy more resilient.
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