The European Central Bank today raised all its key interest rates by 25bps, taking the deposit rate to 3.5%, the refinancing rate to 4% and the marginal lending facility rate to 4.25%.
While the decision to hike by 25bps was widely expected by markets and economists alike, what came as a surprise was how aggressive the staff forecast adjustments were for core CPI. Owing to a tight labour market and the consistently negative forecast error on previous core inflation projections, ECB staff raised their forecasts for core inflation by 0.5pp in 2023 to 5.1%, 0.5pp in 2024 to 3%, and 0.1pp in 2025 to 2.3%. Alongside expectations that headline inflation will remain above the 2% target over the 2-year horizon, the slower projected pace of core disinflation forced markets to reconsider two further rate hikes from the ECB this year just weeks after the prospects of such a scenario were dashed by May’s inflation report, which showed continued improvement in core inflation and signs of disinflation appearing in core services.
ECB revises up its inflation projections heavily, suggesting July may not be the last rate hike
Jerome Powell eat your heart out
Unlike Fed Chair Powell last night, ECB President Christine Lagarde managed to maintain the hawkish tone of the initial press releases throughout the press conference. After months of taking a data-dependent stance to avoid giving explicit forward guidance, President Lagarde returned to massaging market expectations by stating “it is very likely that we will continue to raise rates in July” barring any material changes to the inflation outlook. Compounding this hawkish hawkish rhetoric, when asked about the meaning of a “timely manner”, President Lagarde stated that the current inflation forecast of 2.2% in 2025 is neither sufficient nor timely. As such, the initial rally in eurozone yields and short-term interest rate expectations consolidated throughout the press conference, narrowing interest rate differentials with the US as disappointing data stateside compounded the markets more dovish view on the Fed than the June dot plot projections suggested.
This helped EURUSD extend its rally from the low 1.08 region to break through the 1.09 level; an outcome we earmarked in today’s morning report should the ECB manage to sell a hawkish message more convincingly to markets than the Fed.
Is a 4% terminal rate achievable?
In raising its core inflation projections, forecasting that slack in the labour market won’t appear until at least 2025, and deeming a 2.2% inflation forecast in 2022 as unsatisfactory, the ECB reignited the debate within rates markets over the possibility of a 4% terminal level. While we do believe that there is a considerable risk that this occurs, especially given the prevailing view amongst core Governing Council members that the costs of doing too little continue to outweigh the costs of doing too much, we think markets are ignoring the fractures that are likely to appear within the Governing Council when debating taking rates above 3.75%.
With leading indicators for core inflation also pointing towards continued disinflation, and employment subindices in survey data suggesting labour demand has likely peaked, we believe the balance of risks tilt towards a terminal rate of 3.75% in Q3, with any decision to take rates to 4% likely to prevail in Q4 if at all.
Leading indicators point towards continued disinflation in eurozone core CPI
Hawkish ECB should keep EURUSD at the top of its range
Although we believe market pricing of the ECB’s policy path is likely to be revised lower in the coming weeks as data continues to show improvements in the inflation backdrop, we believe the perceived hawkishness of the ECB should prevent markets from fully pricing out a second hike. With US rates also likely to have topped out, this should keep US-eurozone rate differentials relatively narrower than in recent weeks, allowing EURUSD to trade near the top of its recent range. However, without a substantial improvement in the eurozone’s growth outlook, or a subsequent downgrade to that of the US, we don’t believe this dynamic will lead to EURUSD trading above its year-to-date highs of 1.1095.
The cocktail of a Fed pause and a hawkish ECB narrows rate differentials and leads EURUSD north of 1.09
Simon Harvey, Head of FX Analysis