ECB reveals its strategy with interest rate hikes

The strategy of the European Central Bank (ECB) is coming into sharper focus as the institution is poised to elevate interest rates again this week. Amid this backdrop, the financial markets are keen on discerning the ECB’s course of action beyond July, a trajectory less clearly defined.

For the past year, Eurozone interest rates have climbed by a substantial 400 basis points to 3.5%, a level not seen in over two decades. With inflation gradually slowing and economic strength waning, this rising trajectory appears to be nearing its zenith.

ECB’s upcoming interest rate hike

Financial insiders have predicted a modest hike of a quarter percentage point to 3.75%, an increment that has been incorporated into market forecasts. Despite a cooling headline inflation, a small increase seems justifiable to keep the inflation in check.

All signals from the bank point to a hike this week. “This move by the ECB was predicted, and any diversion from this course would have been a startling deviation,” said Peter Schaffrik, a global macro strategist at RBC Capital Markets.

Post-July, the prospect of a further interest rate increase is increasingly precarious. After some of the ECB’s hawks hinted at a less-than-certain September rise, the bank could pivot towards a more conservative signal, confirming its commitment to data dependence.

Inflation projections for September could provide an opportune moment for the ECB to indicate the achievement of its 2% inflation target, potentially leading to a pause in interest rate hikes.

Similar to the Federal Reserve’s strategy, the ECB might opt to postpone the hike and implement it later if required.

Core inflation, encompassing service prices among others, has shown a persistently increasing trend. Despite the overall inflation reducing for the third consecutive month in June, core prices remain high.

This trend, coupled with a tight labor market and wage pressures, poses a significant concern for the ECB.

Implications of a slowing economy

Despite an economy losing momentum, the bank’s policymakers remain primarily focused on inflation. Even if monetary tightening takes a toll on the economy, the emphasis remains on core inflation.

However, as Eurozone business activity stagnates, dovish policymakers may find their position bolstered. Forecasts by Bank of America point out that ECB’s economic outlook might be excessively optimistic, with Barclays predicting a period of stagnation commencing from the latter half of 2023.

As the ECB pursues the steepest acceleration in borrowing costs in its history, evidence suggests that these measures are beginning to strain credit conditions.

The chief economist of the ECB, Philip Lane, has indicated that loan volumes have seen a marked reduction, a factor that could precipitate a significant downturn in economic output.

This dovish sentiment, if further underscored by the forthcoming bank lending data, might incite speculation that interest rates are on the verge of peaking.

According to Ruben Segura-Cayuela, Europe economist at BofA, “The peak impact of tightening financing conditions will likely occur towards the end of this year and the first half of 2024.”

As the ECB prepares to increase interest rates, market watchers and economists will be closely scrutinizing the ECB’s moves and the potential ripple effects on the global economy.

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