After several false starts, the first European interest rate hiking cycle in more than a decade is set to begin this summer.
The market expects the European Central Bank to raise interest rates by 25 basis points, or 0.25 percent, in July and another 25 basis points in September.
Policy rates are expected to be higher by 1.75 per cent by June 2023. If these expectations are met, it would represent another major change for businesses and consumers to consider as an environment of higher interest rates, potentially affecting their finances.
The ECB has been involved with crisis management since 2011, including the European sovereign debt crisis, as well as the onset of COVID and other shocks, which have led to negative interest rates and huge quantitative easing (QE) events. ECB President Christine Lagarde is facing a situation where growth and jobs are strong and inflation is at 8.1 percent, well above the 2 percent target.
Ms Lagarde described the ECB’s decision to accelerate the wind of its net asset purchases as preparing the ground for the lift-off, saying: “We therefore begin to adjust the policy once the prerequisites are met. we can take additional steps towards policy normalisation.”
This reduction in monetary stimulus comes at a time when Europe faces significant uncertainty and fallout from the Ukraine invasion. So why is the ECB so committed to normalizing interest rates?
effect of inflation
Inflation has been consistently surprising upwards for over a year now.
Central banks expected this growth to be transitory, but high inflation remains. Their confidence in their inflation forecasts has waned and they want to remove housing to thwart rising prices.
While most inflation comes from supply-side pressures, for example higher energy and commodity prices, central banks are forced to use available tools to meet their inflationary mandates. The current cost of living crisis means that politicians who do not wish to relive the 1970s are supportive of this action.
History tells us that inflation, once it takes hold, is very difficult to get out of the economy and out of people’s minds. Central bankers are concerned that high inflation will become embedded in pricing and cause a second round of effects.
The ECB has intensified the wind of net asset purchases, with them expected to liquidate in early July. This opens the door for a rate hike at the July ECB meeting. The final interest rate level for this cycle is the subject of much debate and depends on the growth of wages, inflation and growth.
other central banks
The ECB is not alone in removing the policy adjustment. Several Eastern European central banks have been hiking aggressively in recent months. The Czech National Bank has raised rates from 0.25 percent to 5.75 percent within a year and has set a price to bring interest rates closer to 6.5 percent. Both the Bank of England (BoE) and the US Federal Reserve have raised policy rates and indicated additional aggressive rate increases during 2022. Markets expect the BoE and the Federal Reserve to rise above 2.75 pc and 3 pc respectively in a year.
The ECB is aware that risks to the economic outlook are strong. In particular, Ms Lagarde noted the potential damage from higher commodity prices and the impact of higher uncertainty on business and consumer spending.
The cost of living crisis is felt by everyone and deeply affects those with low incomes.
US research shows that large energy shocks generally lead to precautionary behavior as consumers become more pessimistic. If the growth outlook deteriorates and higher inflation has limited passes for wages, the ECB may decide to be quite gradual in raising rates.
While unemployment levels have not been seen since the 1970s, the ECB is clearly indicating that it does not want to wait and see the effects of the second round materialize.
makes an impact
While the ECB and many private forecasters believe that inflation will decline through 2023, recent actions by the BOE, the US Federal Reserve and others suggest that central banks will cope with such conditions sooner and faster. raise rates.
The possibility of the ECB acting with similar spirits should not be ruled out and interest rate hikes could come in magnitudes higher than the market currently expects.
This will be welcome news for savers, while a stronger euro will help reduce the cost of energy imports.
While the ECB era of crisis management may be relegated to history, the road to policy normalization will still present challenges for policymakers, businesses and the real economy.
Pierce Conati is Head of Euro Rates, Bank of Ireland Markets Group.