Today the European Central Bank raised all three of its interest rates by 25 basis points, bringing the key deposit rate to 4%, in line with our expectation but above the economist consensus.
While the decision to hike or hold was viewed by most within the market as a close call given the mixed data since July’s meeting, in our eyes the decision was cleaner cut. Ultimately, with near-term growth conditions deteriorating at a rapid pace, but underlying inflation still uncomfortably high at above 4%, today’s meeting presented the last opportunity for the central bank to hike without being seen to tip the eurozone economy into recession.
Given the ECB sits deep behind the curve and the disinflationary progress has been sluggish, we believed the allure of an insurance rate hike would prove compelling to most amongst the Governing Council.
While this wasn’t explicitly confirmed within the accompanying rate statement, it was alluded to by the upgraded staff projections, which presented a markedly more stagflationary outlook, and guidance that “if maintained for a sufficiently long duration” interest rates would “make a substantial contribution to the timely return of inflation to target”. Put plainly, it seems as if the Governing Council had struck a compromise. The hawks got the 25bps hike that underlying inflation momentum suggested, while the doves got an early acknowledgement that the bar to resuming the hiking cycle is now so high that it is unlikely to be reached. This is in line with our view that a downturn in growth conditions from here until year-end would prevent any further ECB action and that the latest hike is likely the last of the cycle.
Outside of the interest rate decision, the ECB kept all other policy mechanisms unchanged.
A discussion on an acceleration in the quantitative tightening process was not had, with PEPP reinvestments still set to continue until end-2024. Additionally, no further decision was made on the remuneration of minimum reserves.
ECB’s forecasts look markedly more stagflationary
As we had expected, the updated staff forecasts from June were now considerably more stagflationary, owing to the recent uptick in energy commodities, still-elevated run rate of core inflation, and weaker forward looking growth indicators. The average projected rate of headline inflation was revised up by 0.2pp in 2023 and 2024 to 5.6% and 3.2% respectively, while for 2025 it was marginally downgraded by 0.1pp to 2.1%. The primary reason for the more inflationary outlook stemmed from higher energy costs, owing to an $8 increase in the assumed price of a barrel of oil over the next two years, and changes in regulatory prices. Comparatively, the core inflation forecasts were marginally downgraded, with both the 2024 and 2025 projections lowered by 0.1pp to 2.9% and 2.2% respectively.
In terms of returning inflation to target, the ECB now doesn’t expect this until Q3 2025.
While the downgrades to core inflation suggests there is growing confidence amongst the ECB that inflation is set to return to target over time, we note that these developments took place against a substantial downgrade to growth and a higher market-implied path for interest rates. For reference, the 2025 3-month EURIBOR rate is now assumed at 3.1% vs 2.9% previously.
Furthermore, both headline and core inflation projected above target in 2025, the latest inflation projections are inconsistent with a “timely return”, highlighting the motivation for a further hike.
In terms of growth, the ECB’s staff projections now paint a considerably dimmer outlook. After essentially flatlining in the first half of the year, staff expect growth to remain stagnant in the third quarter (0.0%) and “subdued” in the fourth quarter (0.1%) as manufacturing activity remains weak and services activity is expected to slow. This contrasts with a projected quarterly growth rate of 0.3% in Q3 and 0.4% in Q4 back in June. The growth downgrades didn’t stop there, with the projection for 2024 lowered by 0.5pp to 1% as a result of spillover effects from the second half of this year, while the projected rate of GDP growth in 2025 was lowered by 0.1pp to 1.5%.
ECB’s forecasts become increasingly more stagflationary
Hike and hold
While the ECB and President Lagarde tried to retain optionality in upcoming decisions by stressing data-dependency, it is hard to look beyond the language in the rate statement that suggests the ECB will be responding to any further signs of inflation persistence by lengthening the time in which the deposit rate is held at 4% instead of conducting further rate hikes. This suggests a compromise was struck between the doves and the hawks amongst the Governing Council, which was made apparent when President Lagarde stated that there was a “solid majority” in favour of today’s decision but that “some governors” favoured a pause to assess more data. Looking ahead, we expect rates in the eurozone to remain on hold indefinitely, with rate cuts unlikely to materialise until 24H2 at the earliest.
EURUSD breaks lower on diverging growth paths
With swap markets assigning just a 60% probability of a rate hike from the ECB today after the ECB sources story earlier in the week, there was scope for a minor EURUSD rally on the central bank’s decision to hike today, at least in theory. However, we warned against this outcome, noting that the decision to hike would coincide with a harrowing set of forecast adjustments, which would not just increase the implied probability of a recession on the continent but also lead markets to increase the pace of the easing cycle in 2024. This is ultimately what transpired. The single currency initially fell by 0.25% against the dollar, while markets increased the amount of rate cuts priced into the 2024 EURIBOR strip to 70bps. The single currency then took another leg lower as retail sales and producer inflation data out of the US added to the diverging growth narrative that continues to hang over the currency pair.
EURUSD dives below key support level after ECB decision and strong US data release
Simon Harvey, Head of FX Analysis