Upgrading our view of the ECB rate peak
We have revised our ECB policy rate forecasts. We now expect the ECB to raise its deposit rate to 2% most likely by the end of this year. In our revised base case, we see another 75bp hike in October, followed by a 50bp step in December. The policy rate then settles at 2% through 2023. The most likely alternative to this base, is three steps of 50bp, which would mean the terminal rate is reached in February of next year. We had previously signalled a peak rate of 1.5%.
We now expect the ECB to raise its deposit rate to 2% most likely by the end of this year. In our revised base case, we see another 75bp hike in October, followed by a 50bp step in December. The policy rate then settles at 2% through 2023. The most likely alternative to this base, is three steps of 50bp, which would mean the terminal rate is reached in February of next year. We had previously signalled a peak rate of 1.5%.
The upgrade reflects that the communication from the September Governing Council meeting was more hawkish than we expected. Concretely:
1. The ECB projects that inflation will exceed its target throughout its whole forecasting horizon, to end 2024. Although the overshoot is modest at the end of the period (at 2.2%), it is substantial for most quarters between now and then2. This projection already assumes short-term interest rates climb to around 2%, while President Lagarde also suggested in the press conference that market expectations (that interest rates would rise to somewhat above 2%) were not unreasonable3. Although our forecast for the eurozone economy is much more negative than the ECB’s, the central bank’s downside scenario, which resembles our own in terms of GDP growth, also sees inflation being even more elevated than in its base case. This means that a gas supply cut scenario leading to worse macro outcomes than its base case, would not necessarily be a reason to abort rate hikes.
Whereas we saw the risks to our previous peak rate call as being skewed to the upside, we see the risks to our new forecast as being balanced. On the upside, the ECB’s inflation projection suggests that ECB policy rates may need to go above the 2%, as this is the rate assumed in the forecast, which still led to a moderate overshoot of the target. In addition, although market-based measures of inflation expectations are roughly in line with the target, survey-based measures exceed the target. This means for any given real neutral rate estimate, the neutral rate in nominal terms would be higher.
On the downside, it is possible that the likely upcoming recession would not be accompanied by even higher inflation, as the ECB’s current negative scenario assumes. A key assumption behind that scenario is that gas prices are at 360 EUR/Mwh next year and that oil prices are 138.2 USD/barrel, which is much higher than current market prices.