ECB Follows the Fed!

Despite a slight easing in inflation rates, the situation remains precarious, prompting the European Central Bank (ECB) to implement further interest rate hikes in a bid to control prices. The recent decision, announced late in the evening on July 27, was in line with market expectations, resulting in an increase of 25 basis points across three key rates.

This latest adjustment marks the ECB's ninth rate hike since July of the previous year, pushing the deposit rate to 3.75%, the highest it has been in 22 years. The marginal lending facility also saw a rise to 4.25%, while the refinancing rate remained at the same level.

Although there are signs that inflation within Europe has somewhat moderated—dropping from 6.1% in May to 5.5% in June—an in-depth examination of the underlying data reveals a more concerning picture. The core inflation rate, stripped of volatile components like energy, food, and tobacco, actually rose from 5.3% in May to 5.5% in June. This illustrates that even after controlling for these fluctuations, inflationary pressures persistently mount. The ECB has long established a target inflation rate of 2%, a figure that current data clearly exceeds.

Further complicating matters, the ECB indicated that inflation expectations are likely to remain high for an extended period.

The ECB finds itself navigating a delicate balance between quelling inflation and fostering economic growth.

The Purchasing Managers' Index (PMI) for July indicates a downturn in service sector demand, while manufacturing has contracted at a pace not seen since the onset of the pandemic. Observers note that the overall slowdown in economic activity has exceeded outside expectations.

Recent surveys of business activity in the Eurozone revealed contraction in key economies, including Germany and France. Analysts from ING point out that these findings amplify the risk of the Eurozone slipping into recession this year.

During a press conference following the meeting, ECB President Christine Lagarde acknowledged the heightened uncertainties surrounding economic growth and inflation. She highlighted the downward risks to growth, including the ongoing conflict that has inflamed regional tensions and severely impacted global energy and food markets. Positioned as a neighbor to this conflict, Europe is acutely affected; rising energy prices have inflated living costs for both businesses and consumers, while trade has also been hindered. Additionally, the broader geopolitical tensions further disrupt global trade norms, placing severe restrictions on the Eurozone economy, which is heavily reliant on international trade. Lagarde forecasted continued economic weakness in the near term but noted that, over time, declining inflation, rising incomes, and improved supply conditions should bolster economic recovery.

In a significant development, the ECB removed explicit references to potential further rate hikes from its policy statement, suggesting that an increase at the next meeting in September is no longer a given. The central bank has refrained from offering forward guidance regarding upcoming actions, indicating that future interest rate decisions will hinge on assessments of the inflation outlook, with key rates maintained at sufficiently stringent levels to ensure inflation gradually returns to the target.

Lagarde mentioned a flexible approach towards decisions for September and beyond, considering both the potential for further rate hikes as well as the possibility of pausing them, albeit with no intention to lower rates.

Market sentiment currently views the likelihood of a 25 basis point increase by the ECB in September at 40%, down from a previous 44% probability.

Nadia Gharbi, a senior economist for wealth management at Pictet, expressed that the data leading up to the ECB meeting on September 14 will be critical in determining the feasibility of raising rates to 4%. She noted that signs are mounting indicating that monetary tightening policies are swiftly impacting the real economy. Continuously, there’s a concern that core inflation could retain its momentum, consequently undermining the rationale for pausing rate hikes in September. “Thus, a September increase is not set in stone; however, we believe it will mark the last hike in this cycle, pushing deposit rates to 4%. The key aspect will be observing the ECB's approach to maintaining that rate level over the long term. We anticipate that the ECB will not consider lowering rates until at least the second half of 2024.”