ECB baseline sees further hikes, but market conditions could be key
1. The ECB raised its key policy rates by 50bp. This was in line with our base line and the consensus of economists, however doubts had surfaced on the size of the move over the last few days due to the banking sector worries. Markets were pricing in a high chance of a smaller move in the run up to the meeting.
2. The Governing Council dropped all guidance on future policy rate moves. The statement noted that ‘the elevated level of uncertainty reinforces the importance of a data-dependent approach to (…) policy rate decisions’.
3. Although guidance has been left open, it seems likely that the ECB’s bias is still towards further rate hikes, at least if its baseline scenario plays out. For instance, the statement noted that ‘inflation is projected to remain too high for too long’. Indeed, though revised down, headline inflation is not expected to return to target until the middle of 2025. Crucially, this is predicated on further rate hikes (around 50bp beyond today’s move). This was also mirrored by President Christine Lagarde noting that if its baseline plays out, that there is ‘more ground to cover’.
4. However, Ms Lagarde was clear to point out that the baseline does not include recent financial market tensions, which ‘imply additional uncertainty around the baseline assessments of inflation and growth’. It is too early to fully assess the impact of current market tensions. As it stands, bank equity, bond and CDS levels do not point to more stress than seen for instance at points during last year. However, there is a risk that market tensions escalate further.
5. The ECB’s future monetary policy decisions will not only be based on its forecast for inflation, but also current developments in underlying inflation as well as the transmission of monetary policy. Here it saw mixed developments. It saw only marginal improvements in underlying inflationary pressures currently, which remained too high. However, it did see signs of transmission of its rate hikes through the ‘credit channel’.
6. The ECB expressed confidence in the banking sector, while setting out that it stood ready to act if needed. It noted that it is ‘monitoring current market tensions closely and stands ready to respond as necessary to preserve price stability and financial stability in the euro area. The euro area banking sector is resilient, with strong capital and liquidity positions’.
7. It clarified that any action would be focused on providing liquidity. It noted that ‘the ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy’.
8. Lagarde was also clear that the ECB does not see a ‘trade off’ between preserving price stability and financial stability, as they have different tools to address these. This is because it would only change its monetary policy stance in the face of market tensions if financial conditions tightened enough to change the inflation outlook. If not, the monetary policy trajectory would be the same, while it would use other tools to restore financial stability. As well as liquidity measures for banks, it could also resume reinvestments in our view.
9. Our baseline scenario sees the ECB policy rate peaking at 3.75% before a rate cut cycle begins in December and continues during 2024. Today’s ECB meeting suggests that the risks are now skewed towards a lower peak for two reasons. We expect economic growth to turn out weaker than the ECB expects as the impact of monetary tightening dampens demand more strongly than in the central bank’s projections. However, there is uncertainty about how quickly that comes through convincingly in the macro data. Meanwhile, although we agree with the ECB that eurozone banking sector fundamentals are generally solid, there is a risk that financial market tensions continue to escalate to the extent that financial conditions tighten more sharply.