The European Central Bank (ECB) is expected to halt the most aggressive series of interest rate rises in its history when policymakers meet in Athens, Greece, this week. Yet with euro zone inflation running at more than twice its target and the Israel-Hamas conflict pushing up energy prices, ECB president Christine Lagarde is expected to make clear that rates are likely to stay at – or above – their current level for some time.
Most investors, looking at this year’s near-stagnation of the euro zone economy and the downward trajectory of inflation, view the chances of a further rise in euro zone rates as slim. “They will keep the option open for additional rate hikes, but the bar is pretty high for that to happen,” said Konstantin Veit, a portfolio manager at US investment group Pimco.
Yet the idea of euro zone interest rates staying higher for longer than anticipated earlier this year is gaining ground despite signs that the region’s economy is hardly growing.
“Only a month ago the market had three full rate cuts priced in for the ECB next year, but now it is pricing in slightly more than two,” said Veit. “There are still a lot of risks for inflation out there and it is too early to say exactly how soon the rate cuts will start.”
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In response to a double-digit surge in Europeans’ cost of living, the biggest for a generation, the ECB has raised borrowing costs at 10 consecutive meetings. This lifted its benchmark deposit rate from an all-time low of minus 0.5 per cent to a record high of 4 per cent. Officials remain cautious, however, about how long it will take to complete the “last mile” of their journey in returning inflation to their target of 2 per cent.
Ms Lagarde said this month that price pressures remained “undesirably high” despite dropping to nearly a two-year low of 4.3 per cent last month. The rate is expected to drop even further in October, though data is not published until a few days after this week’s meeting.
More evidence that economic activity was weakening and inflation was cooling came on Tuesday, when the latest survey of purchasing managers pointed to further declines in euro zone business output, a stepping up of job-cutting and a drop in price pressures affecting companies.
The ECB’s own survey of banks also showed a continued contraction in the supply of credit to households and businesses from euro zone banks.
However, the conflict between Israel and Hamas has raised fears of wider tensions in the Middle East and pushed up oil and gas prices in recent weeks, which economists worry could keep inflation stubbornly high. “The attacks on Israel, and the potential knock-on effects on the oil market pose a new upside risk to inflation,” said Dirk Schumacher, a former ECB economist who is now at French bank Natixis.
“Downside risks to growth, at the same time, have also increased, complicating the picture further for the ECB.”
Greek central bank governor Yannis Stournaras, who is one of the ECB’s 26 governing council members, said recently that it should avoid a “knee-jerk reaction” to the jump in energy prices caused by the Middle East conflict.
ECB chief economist Philip Lane also played down fears, saying higher borrowing costs should prevent higher prices from causing a broader surge in consumer prices. “When rates are restrictive then the ability of firms to pass on those energy price increases into consumer prices is less,” Mr Lane told the Dutch newspaper Het Financieele Dagblad.
But Mr Lane also voiced concern about soaring incomes, which rose 4.5 per cent in the region in the year to the second quarter. “We need to see wage growth slow down. If inflation shocks are sufficiently large or persistent the ECB will have to be open to doing more.”
Rate-setters are also expected to discuss the possibility of tightening monetary policy via their balance sheet.
Up for debate is whether to stop reinvesting the proceeds of a €1.7 trillion portfolio, bought in response to the pandemic, earlier than expected.
The recent sell-off in bond markets, which drove government borrowing costs up to their highest levels for a decade, has made some nervous about shrinking the balance sheet, however. They say the ECB needs the flexibility to target the proceeds of maturing bonds more towards the debt of any country hit by a sharp divergence, or fragmentation, in financing costs compared to others.
Italy’s borrowing costs have already risen more than those of Germany on concerns about Rome’s rising fiscal deficit, taking the closely-watched spread between the two countries’ 10-year bond yields above 2 per cent for the first time in months. “Given the rise in long-term yields – with 10-year Italian yields around 5 per cent and additional fiscal risks – we expect the ECB to move cautiously,” said Sven Jari Stehn, economist at Goldman Sachs.
Some ECB council members are also pushing for it to cut the interest it pays to commercial banks. Rate-setters would do so by increasing the minimum amount of reserves the sector needs to park at the central bank, on which lenders earn nothing.
The idea is controversial as it seems mainly designed to reduce the heavy losses some euro zone national central banks are racking up rather than contributing to the fight against inflation. “If concerns about central bank losses intrude into policy and the ECB seems to have other objectives apart from price stability then it could negatively affect central bank credibility,” said Mr Veit at Pimco.
The debate is unlikely to be settled until the ECB completes a wider review of its operating framework. That review, which will assess the optimum size of its balance sheet, is due to be completed next spring. – Copyright The Financial Times Limited 2023
