At today’s meeting, the European Central Bank’s (ECB) Governing Council (GC) pronounced the end of all asset purchases on 1 July (but de facto earlier), and committed to a 25-bp hike at the meeting on 21 July—so “sometime after” the end of purchases, in line with previous guidance on sequencing. Moreover, the ECB also expects to hike again at the September meeting, with a 50-bp hike now likely unless the inflation outlook improves by then. After September, the ECB expects further rate hikes to be necessary, albeit back at a slower pace.
Notably, the GC also changed the wording around liquidity conditions from “favourable” to “ample” and more importantly, from “ample accommodation” to “appropriate” with regard to the policy stance. The ECB thereby irrevocably sets its sights on a continued policy-tightening trajectory, with the main questions relating to frequency, speed and length of the cycle. With respect to frequency, ECB President Christine Lagarde explained in the press conference that the ECB may also hike at non-forecast meetings (so not only July but possibly also October this year). Regarding speed, Lagarde repeated that the GC’s expectation was for a larger (more than 25 bps) hike in September unless the medium-term—i.e., 2024—inflation outlook improves by then. Finally, Lagarde noted that the GC has decided not to discuss the question of where the neutral level of policy rates is, indicating that the length of the hiking cycle is an open question at this point.
Separately, Lagarde refused to discuss a much-rumoured new instrument geared at ensuring balanced monetary transmission (and avoiding fragmentation), stating that the (flexible) reinvestment policy is the primary tool to counter such dynamics at his point. She did note, however, that the reinvestment policy could be modified in the future to have a stronger “green” aspect.
ECB staff also provided a new round of macroeconomic projections for the eurozone. The new baseline scenario is essentially a blend of the downside scenarios from the March projections, with 2022 growth now projected at 2.8%, as well as 2023 and 2024 at 2.1% each. Inflation projections (headline) have been revised up as expected, touching 7.5% this quarter and 6.8% for the year as a whole, while falling back to 3.5% and 2.1% in 2023 and 2024, respectively. Notably, the ECB also expects core inflation to remain above 2% over the projection horizon (at 3.3%, 2.8% and 2.3%, respectively). While the inflation revisions largely account for continuous upside surprises in the recent past, in line with the severe scenario from March (albeit without any actual energy supply shortfall), the growth revision is somewhat less pronounced than that. This reflects a shift of growth momentum from 2022/2023 into 2024, largely driven by the longer expected duration of the war in Ukraine, but also by a slightly more upbeat near-term growth outlook given a marked activity rebound in selected sectors as pandemic constraints are relaxed. The baseline projections are close but somewhat more optimistic, especially for 2023, when compared to the Organisation for Economic Cooperation and Development’s (OECD) most recent forecast, published yesterday.
ECB staff also introduced a new downside scenario, which assumes disruptions to energy supplies leading to a significant recession in 2023 and a strong but incomplete rebound in 2024. Average inflation in the downside scenario is projected at 8% for this year and 6.4% for next year, falling back to 1.9% in 2024 on base effects.
Our View
With today’s meeting, the ECB attempted to get back into the driver’s seat after a period when constant upside inflation surprises drove market pricing for policy rates higher. First, regarding July, the GC attempted to put an end to escalating expectations by firmly committing to a 25-bp lift-off, and given the explicit precision, it is very hard for us to imagine a larger step. Second, the ECB essentially reversed the burden of proof for September in the sense that inflation projections need to improve—not just remain constant—to tip the balance back from a larger hike toward a 25-bp hike. This is a significant concession to the hawkish end of the spectrum on the GC. Third, and contrary to our expectations, Lagarde did not discuss the new downside scenario related to rationing of energy supplies. Instead, she talked relatively confidently about strengthening wage dynamics supporting the medium-term growth outlook, citing among other things the minimum-wage hike in Germany. While the ECB’s baseline growth expectations are a touch optimistic in our view, it is noteworthy that they remain significantly above the potential growth rate in Europe.
Overall, today’s ECB meeting came as yet another hawkish surprise to markets and bond yields reacted accordingly. Since the near-term commitments on rate hikes made by President Lagarde were essentially fully priced ahead of the meeting, the surprise element clearly came from the longer-term outlook on growth and the durability of the hiking cycle, which drove yields higher in the core and especially the periphery. One additional reason for the reaction in bond yields might have been unfulfilled expectations regarding the new anti-fragmentation instrument. We continue to believe that the risks to the interest-rate trajectory are to the downside given the risks, but for now, onwards from asset purchases and upwards with interest rates!