ECB View - Revising our view of the terminal rate higher, but with cuts by the end of 2023

We now expect the ECB to raise its deposit rate to 2.50% by the end of 2023Q1. Previously, our base case was for the ECB to hike to a peak level of 2.0% in December 2022 and, subsequently, pause. We now also expect the central bank to start cutting rates again in the final quarter of 2023.

A number of factors made us change our view. First, there has been a clear hawkish tilt to the language of communication by several ECB officials since the October Governing Council meeting. For instance, the press statement after the October meeting mentioned the Governing Council had made ‘substantial progress in withdrawing monetary policy accommodation’, whereas on 4 November, ECB president Lagarde mentioned ‘our job is far from being completed’. She also suggested that ‘withdrawing policy accommodation would not be enough to bring inflation back to the target’, which seems to suggest that rates would need to be raised to levels above 2%.

In addition, economic data published after the Governing Council meeting was stronger than expected, with Q3 GDP growth coming in higher than the consensus forecast and also higher than the ECB’s own forecasts according to its September staff macroeconomic projections. Moreover, inflation unexpectedly jumped higher in October (to 10.7%, up from 9.9% in September), implying that the average inflation rate in 2022Q4 will probably also be well above the ECB’s own projections (of 9.2%). Finally, the ECB is worried about the current pace and intensity of the pass-through of energy and food price shocks into underlying inflation, which is much faster and higher than in the past. 

Having said all this, we do think that macro trends are set to shift markedly over the next few months. We think the eurozone economy has entered a recession, with GDP expected to contract noticeably throughout 2022Q4-2023Q2 and growing only modestly in 2023H2. Moreover, inflation is expected to be close to peak levels now and should decline moving into 2023, with food and energy commodity price inflation having eased in recent months, supply chain bottlenecks dissipating and pay settlements remaining well behaved. This should set the scene for an end to rate hikes in Q1 of next year. In addition, towards the end of next year, these macro trends mean that restrictive monetary policy will no longer be necessary. As such, we expect the ECB to start cutting rates in the final quarter of 2023.