After many false dawns, Europe’s first rate hike cycle in more than a decade looks set to begin this summer.
Markets expect the European Central Bank to hike interest rates by 25 basis points, or 0.25 percentage point, in July and another 25 basis points in September.
Policy rates are expected to be a full 1.75 percent higher by June 2023. If these expectations come true, it will be another big shift for businesses and consumers to consider as a higher interest rate environment is likely to affect their finances.
The ECB has been associated with crisis management since 2011 following the European sovereign debt crisis, as well as the outbreak of Covid and other shocks that led to negative interest rates and large-scale quantitative easing (QE) programmes. ECB President Christine Lagarde faces a situation where growth and jobs are strong and inflation is well above the 2% target at 8.1%.
Ms Lagarde described the ECB’s decision to accelerate the unwinding of its net asset purchases as preparing the ground for launch, saying: “We have therefore started to adjust monetary policy so that when the necessary conditions are met, we can take additional steps to to normalize monetary policy”.
This reduction in monetary stimulus comes at a time when Europe is facing significant uncertainty and the fallout from the invasion of Ukraine. So why is the ECB so committed to normalizing interest rates?
Impact of Inflation
Inflation has been a consistently positive surprise for more than a year.
Central banks expected this surge to be temporary, but higher inflation persisted. Their confidence in their inflation forecasts has shrunk and they want to dismantle housing to counter rising prices.
While much of inflation stems from supply-side pressures, such as higher energy and commodity prices, central banks are being forced to use the tools available to fulfill their inflationary mandate. The current cost of living crisis means politicians who don’t want to relive the 1970s are backing this action.
History teaches us that inflation, once established, is very difficult to get out of the economy and out of people’s minds. Central bankers fear that higher inflation will feed into pricing and cause second-round effects.
The ECB has accelerated the unwinding of net asset purchases and expects them to end in early July. This opens the door for rate hikes at the July ECB meeting. The level of the final interest rate for this cycle is a much-debated topic and depends on wage, inflation and growth developments.
Other Central Banks
The ECB is not the only one to reverse monetary policy adjustments. Many Eastern European central banks have hiked aggressively in recent months. The Czech National Bank has hiked interest rates from 0.25 to 5.75 percent in less than a year and is expected to take interest rates to almost 6.5 percent. The Bank of England (BOE) and the US Federal Reserve have both hiked interest rates and signaled more aggressive rate hikes throughout 2022. Markets expect the BOE and Federal Reserve to hit highs of about 2.75 percent and 3 percent, respectively, a year from now.
The ECB is aware that the risks to the economic outlook are high. Ms Lagarde specifically mentioned the potential damage from high commodity prices and the impact of heightened uncertainty on business and consumer spending.
The cost of living crisis is affecting everyone and is having a profound impact on those on lower incomes.
US research shows that large energy shocks typically lead to cautious behavior as consumers become more pessimistic. If growth prospects deteriorate and high inflation only has a limited impact on wages, the ECB could decide to raise interest rates gradually.
However, with unemployment levels not seen since the 1970s, the ECB is clearly signaling that it will not wait for second-round effects to materialize.
While the ECB and many private forecasters expect inflation to ease in 2023, recent actions by the BOE, Fed and others suggest that central banks tend to hike rates earlier and faster when they faced with these circumstances.
The likelihood of the ECB adopting a similar hawkish stance cannot be ruled out, and rate hikes could be larger than markets are currently anticipating.
This would be welcome news for savers, while a stronger euro would help lower the cost of energy imports.
While the ECB era of crisis management may be a thing of the past, the path to policy normalization will still pose challenges for policymakers, businesses and the real economy.
Pearse Conaty is Head of Euro Rates, Bank of Ireland Markets Group
https://www.independent.ie/business/european-central-bank-must-be-wary-of-raising-interest-rates-too-quickly-41723568.html The European Central Bank must be careful not to raise interest rates too quickly