• ECB Rates to rise 25 bps in July and probably by 50bps in September
• Further sequence of hikes set to follow unless inflation falls markedly or economy weakens severely
• Today’s announcement signals a notable shift towards hawkishness
• Keeping full control of policy path and market expectations could prove tricky as Fed and Bank of England experience suggests
• Markets now see rates increasing 100-125 basis points this year and about 100 basis points in 2023  
• Impact on Irish economy less severe than in past because of changes in household borrowing and saving patterns but still represents an additional downside risk to the outlook for domestic spending.    

The ECB today signaled its intention to raise its key policy rates further and faster than it had previously suggested in what was quite a hawkish set of pronouncements.

As clearly indicated by a range of senior officials in recent weeks, the ECB today confirmed that it intends to raise policy rates for the first time in decade at its next policy meeting on July 21^st. It also  pre-announced  a further interest rate increase for its September policy meeting.

Although a tightening of ECB policy has been widely expected for some time, three elements of today’s ECB comments point towards a somewhat more aggressive policy path into 2023 than was generally envisaged.  

3 pointers to notably tighter policy ahead 

The first hawkish signal is that while the rate rise signalled for July is a widely predicted 25 basis points, the strong likelihood is that September will see an increase of 50bps. This is suggested in the wording of today’s statement that notes ‘If the medium-term inflation outlook persists or deteriorates, a larger increment will be appropriate at the September meeting’.

So, a half per cent increase in interest rates is now the central case. Unless there is a dramatic reversal of current upward pressure on energy prices through the summer, it seems that September will see ECB policy rates rise by a further 50bps.

A second hawkish signal from the ECB today is the indication that ‘Beyond September, based on its current assessment, the Governing Council anticipates that a gradual but sustained path of further increases in interest rates will be appropriate.’

This suggests that the ECB will continue to move rates higher in a mechanical fashion until the outlook for inflation improves and/or the outlook for activity and employment deteriorates markedly.

In other words, rather than pointing to a finite number of rate hikes, the ‘default option’ for the ECB for some significant time to come will be to raise rates once or twice a quarter. This chimes with ECB president Christine Lagarde’s indication today that the ECB is now on a ‘journey’ in relation to adjusting its monetary policy.

The third hawkish signal sent by the ECB relates to three aspects of its new projections.

First of all, it may be noted that in terms of its inflation projections, the ECB’s estimate of a headline inflation rate at 6.8% in 2022 and 3.5% is somewhat below forecasts of many other institutions (including KBC), the fact that the ECB sees inflation in 2024 at 2.1%, still above its medium term target of 2%, albeit marginally, points towards a sense that a protracted struggle against high inflation lies ahead.

The sense that somewhat higher inflation risks becoming embedded in the Euro area is further highlighted by the latest ECB forecasts for underlying inflation that see ‘core’ inflation at 3.3% in 2022, only slowly unwinding to 2.8% in 2023 and 2.3% in 2024.

Importantly, the ECB sees risks to inflation still skewed to the upside and stemming from a wide range of sources including ‘ a durable worsening of the production capacity of our economy, persistently high energy and food prices, inflation expectations rising above our target and higher than anticipated wage rises.

In addition, in circumstances where a range of ECB speeches have pointed to longer term structural upside risks to inflation from decarbonisation, some threat of de-globalisation and the eventual inclusion of housing costs into the inflation index, the ECB‘s expectation that core inflation will remain clearly above its target in 2024 points towards circumstances in which monetary policy likely needs to be materially tighter.

The final element of hawkishness in relation to the new projections is that the ECB is notably more upbeat than many others about the capacity of the Euro area economy to weather some major headwinds to growth. Although the ECB's GDP growth forecasts have been downgraded for 2022 and 2023, the cumulative shortfall compared to the March projections at 1.6 percentage points is only about half of the scale of the upward revision to inflation through the same period.

Moreover, whereas inflation remains in problematic territory in 2024 in the new ECB projections, the new GDP growth estimate for 2024 at 2.1% is materially healthier than the previous estimate of 1.6% and is well above the ECB’s long term growth rate. 

Some sense of why the ECB feels a need to move fast and possibly far is suggested by the diagram below.

How far, how fast and how tricky?

Today’s ECB announcement is important in many respects. It underscores a now firmly established global trend whereby central banks and markets are repeatedly and rapidly upgrading their estimates of the outlook for inflation and, by extension, signaling altogether more forceful paths of policy tightening.

Perhaps informed by the difficulties both the US Federal Reserve and the Bank of England have faced in sticking to previously announced policy paths, the ECB has given itself ‘hawkish optionality’ by suggesting today that they are set on a ‘journey’ entailing an almost mechanical sequence of rate increases through the remainder of this year and into next.

Although the ECB is established almost a quarter century, it does not have a great deal of experience of policy tightening cycles but, in past ECB cycles, tightening was substantial and speedy.

The fledgling institution raised rates by 225 basis points in eleven months between November 1999 and October 2000. Between December 2006 and July 2008, the increase in ECB policy rates was 200 basis points. The only other occasion of raising rates- which proved a significant error was the two rate increases totaling 50 basis points that occurred in April and July 2011. 

Markets now expect another relatively substantial if short tightening cycle. Futures pricing would suggest the ECB could raise rates by some 100-125 basis points by the end of this year and by about a further 100 basis points in 2023. Although these expectations can change rapidly, it seems markets now see ECB rates peaking in the broad region around 2 percent late in 2023 or early in 2024.     

A further problem for the Irish economy but not like before 

For the Irish economy, higher ECB rates will likely represent a further material headwind to domestic activity. Lower levels of household borrowing in recent years coupled with a greater uptake of fixed rate loans, together with a significant increase in household deposits means that the mechanical consequences for the Irish economy of rising interest rates are less threatening than in the past.

Indeed, household deposits (€144bn in April) are now than household loans (€102bn in April). However, the propensity of borrowers to spend is notably higher than that of savers.  Moreover, in current conditions of elevated uncertainty, concerns about a possible substantial and speedy increase in borrowing costs represent a source of material downside risk to the outlook for domestic spending.  

In the same manner, the rise in ECB rates will add to upward pressure on Government borrowing costs.> As the graph below illustrates, a rising trend in bond yields has been in place since the turn of the year as markets began to sense an emerging shift in ECB thinking.

At around 2.05% today, the cost of 10 year money for the Irish Government is materially higher than it was through the past couple of years but it remains on an altogether less threatening trajectory than in previous problem episodes. There are much larger and more immediate policy problems facing the Irish Government In terms of current cost of living problems and addressing serious shortcomings in economic and social infrastructure. Higher borrowing costs mean the responses to these issues need to be carefully crafted rather than postponed.