ECB’s rate hike plan may well be cut short
ECB View: Slowdown in pace of hikes, but hawkish message. The ECB decided to raise its key policy rates by 50bp at its meeting today, which was as expected. Although this represents a slowdown in the pace of rate hikes, most other elements of the announcement were decidedly hawkish.
First, it signalled that ‘interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target’. ECB President Lagarde later clarified in the press conference that this language pointed to further 50bp steps.
Second, the staff macroeconomists raised their inflation projections and showed inflation remaining relatively high even in 2025 (see ). Inflation would only come down to be consistent with the target in 2025H2. All this was predicated on a policy rate of 2.75-3% at the end of next year, suggesting that the ECB would likely be minded to go well above those levels in order to get inflation at target earlier in its forecast horizon.
Third, the ECB announced a tapering of reinvestments for the APP portfolio. It announced that ‘from the beginning of March 2023 onwards, the asset purchase programme (APP) portfolio will decline at a measured and predictable pace, as the Eurosystem will not reinvest all of the principal payments from maturing securities. The decline will amount to EUR 15 billion per month on average until the end of the second quarter of 2023’. The subsequent pace still has to be decided. On average, ECB APP redemptions during next year are EUR 28bn on a monthly basis, but this is a little higher over the March – June period (at just under EUR 33bn). It seems the ECB will reinvest a little more than half of what matures. More details will follow in February.
We are sceptical about the ECB’s relatively sanguine view on economic growth and hawkish view on inflation. With a GDP growth forecast of 0.5% for 2023, the ECB remains bullish relative to consensus (-0.1%) and especially versus our own forecast (-0.9%). This also explains why the central bank expects the labour market to remain tight and wage growth to accelerate very sharply and remain high throughout its forecasting period. In addition, it seems to assume long and substantial pass-through of previous commodity and industrial cost pressures into inflation. We think given the flattening out of commodity prices, easing of supply chain bottlenecks and a deeper and longer recession, inflation will fall more quickly towards the ECB’s target.
Nevertheless, given the ECB’s communication we now expect a 50bp hike at the February meeting (previously 25bp), but continue to pencil in a 25bp move in March. So we lift our forecast for the peak ECB rate to 2.75% from 2.5% previously. We assume that by March, macro data will be coming in below the ECB’s projections and that this trend will continue. Looking further forward we expect 50bp of rate cuts in Q4 of next year. Given we expect a significant recession, higher unemployment and inflation to fall sharply, this should reduce the need for restrictive policy.