The European Central Bank is likely to be the next major central bank to raise interest rates next month.
Our assessment of the current ECB policy stance using a modified Taylor rule implies that, given the current global supply shock, the ECB’s monetary policy is too accommodative and the central bank needs to lift rates to maintain price stability.
Traditionally, central banks tend to look through supply shocks, preferring to wait until they can ascertain the point at which top-line inflation bleeds into the core and inflation expectations begin to be reset higher.
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But given the severity of the supply shock this time around, policymakers may not have the luxury of time.
While we expect a 25 basis-point increase at the ECB’s meeting on June 11, the central bank will be cautious for the rest of the year as it tackles the stagflationary impact of the energy shock that is every central banker’s worst nightmare.
At the ECB’s last meeting, the central bank left interest rates on hold at 2.0%. But ECB President Christine Lagarde suggested that unless the Strait of Hormuz had reopened by the next meeting, then June would be the “right time” to cast judgment. “Directionally, I know where we’re heading,” she said at the time.
That’s a clear signal that interest rates are likely to go higher, even if the degree of tightening remains more opaque.
The ECB is facing the same quandary as most central banks around the world: How to tackle the simultaneous upward pressure on inflation as the economy is taking a hit from the supply shock.
For the ECB, which keeps a tighter leash on inflation than the Bank of England or the Federal Reserve, this probably means a rate hike next month.
Any tightening cycle will be shallow and short-lived compared to 2022, when the ECB hiked rates by 450 basis points. That’s because the economy is weaker and the labour market is looser than in 2022.
For example, the vacancy rate has declined by a third since it peaked in 2022 and the ECB’s negotiated wages tracker is running at 2.5%, below the 3.0% level that policymakers judge to be consistent with 2.0% inflation.
The softer labour market reduces the likelihood of second-round effects from workers bidding up nominal wages in response to higher inflation, which should help to avoid increased core inflation.
That means aggressive rate hikes probably won’t be needed this time, but financial markets are still pricing in two hikes with a risk of a third over the next year.
Rather than pushing back against market pricing, Lagarde, seeing a softer labour market, restrained economic growth and core inflation close to target, has acknowledged that “our reaction function is well understood.”
That’s central banker-speak for market expectations are in the ballpark.
Of course, policy moves beyond June will depend on how the war with Iran unfolds.
But we think energy prices would need to rise much further to warrant more than two rate hikes, as even in the ECB’s adverse scenario—which energy prices are currently below—headline inflation would return to the ECB’s 2.0% target in the second quarter next year before undershooting that level.
