ECB Interest Rate TBA | Will High Inflation Drive the Pace for Interest Rate Hikes?

Tonight, the ECB will announce its interest rate decision. Inflation in Europe is already above 5%, and it is not expected to fall back any time soon. Europe has maintained the accommodative monetary policies of the pandemic, but the ECB may be forced to embrace more hawkish measures to curb rising inflation. The ECB’s February monetary policy meeting minutes showed that members had agreed that the size of its quantitative easing program should start shrinking.

At the ECB meeting in mid-December last year, the ECB left the three major interest rates unchanged.  The benchmark rate remained unchanged at 0.000%, while the deposit rate was left at -0.500%. Still, the ECB decided to withdraw the stimulus measures implemented during the pandemic period gradually. The ECB planned to eventually stop the 1.85 trillion euros ($2.1 trillion) pandemic emergency asset acquisition program (PEPP) in March 2022.

However,  as the ECB starts to adjust its policy direction in March, markets are concerned about whether more hawkish measures will be announced at tonight’s meeting and whether the number and timing of interest rate hikes will be mentioned.

 

It is difficult for Inflation in Europe to fall in the short term

European economic growth is expected to slow down this year as the COVID-19 variant virus spreads across the old continent, coupled with geopolitical tensions that have triggered higher energy prices, supply-demand imbalances, and inflation. As a result, the European Commission raised its inflation targets for Europe to 3.5 percent this year in February. Still, it believes inflationary pressures in Europe are likely to fall next year as energy prices fall. As a result, the commission expects inflation to fall to 2.1 percent in the fourth quarter of 2022, with further declines in 2023.

However, the outlook for the European economy does not seem very optimistic, with the February CPI released by the European Union showing that eurozone inflation jumped to 5.8% from 5.1% in January, and the core CPI rose to 2.7% from 2.3%. These figures are well above the ECB’s target inflation rate of 2%. Accompanied by slower economic growth, JPMorgan Chase & Co. has cut its European growth forecast for 2022 by nearly a percentage point and currently expects European GDP to grow by 3.2% this year, while economic growth is expected to be almost zero in the second quarter.

Indeed, it is too early to assume that European inflationary pressures will gradually retrace, depending on whether energy supplies can keep up with demand in the short term. The outlook for Europe’s economy and inflation remains highly uncertain. Russia is the leading natural gas supplier to Europe, and the Russian gas pipeline passes through Ukraine. If the military conflict between Russia and Ukraine escalates further depends on the outcome of the negotiations between the two sides. If the war between the two countries continues in the future, it will further push up the price of natural gas in Europe, and inflation levels may keep rising.

 

Will the ECB choose to raise interest rates this year?

To avoid further economic slowdown due to rising interest rates, ECB President Christine Lagarde said earlier that the ECB would not start raising interest rates before ending its bond-buying program. She reassured investors that any policy adjustments would be gradual. However, the euro fell further against the dollar due to the geopolitical situation in Ukraine and hit a new 2022 low around 1.082. However, the upside risk to inflation in Europe is increasing as every 10% rise in oil prices will trigger a 0.2 to 0.3 percentage increase in European inflation. This has led analysts to predict that the ECB may send more hawkish signals at tonight’s meeting and accelerate the launch of tightening policies. The market is also concerned about the ECB’s response to the recent surge in Inflation in Europe caused by the war between Russia and Ukraine. As for the final timing of future rate hikes, it is necessary to consider the possible impact of the rate hikes on European economies and financial markets and the latest changes in the geopolitical situation. According to a Reuters survey of economists on March 1-4, most expect the ECB to wait until the end of 2022 to initiate its first rate hike in 10 years. Market participants generally expect the ECB to raise interest rates by 25 basis points in December, after which it was expected to raise rates in February 2023.

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