By Patrick Barbe
The European Central Bank raised its key rate by 25 basis points as expected, but startled investors with its outlook.
The European Central Bank decisions last week were in line with market expectations: The central bank raised its deposit rate by 25 basis points and announced the end of reinvestment of maturing bonds in its Asset Purchase Program portfolio.
However, a hawkish surprise came from ECB inflation forecasts, which showed higher outlooks for the core rate this year and next. Indeed, projections for inflation excluding energy and food were revised upward as a consequence of the robust labor market and the rise in unit labor costs – up 5.1% in 2023 and 3% in 2024 compared to March’s outlooks of 4.7% and 2.5%, respectively.
In fact, core inflation expectations had been too optimistic and needed to be revised higher. Nevertheless, ECB President Christine Lagarde noticed small signs of softening inflationary pressures, even as underlying pressure remained strong.
Such upward revisions are likely to prevent the ECB from ending its tightening cycle. However, the committee press release and Lagarde’s comments proved dovish.
The ECB explained that a high level of uncertainty reinforces the importance of its data-dependent approach, which will consider not only inflation but also economic growth and financial conditions. Lagarde said that a July rate hike of 25bps is very likely but didn’t mention the possibility of multiple hikes to come as she has in previous meetings.
She underscored for the first time that “past rate increases are being transmitted forcefully to financing conditions and are gradually having an impact across the economy. Borrowing costs have increased steeply and growth in loans is slowing.” The ECB does not currently see a wage price spiral.
Overall, the ECB decision and explanations ultimately do not change our outlook of 3.75% for the ECB peak rate. In the future, ECB policy will likely be data-dependent, particularly on core inflation, whose new forecasts did not take into account the latest fall in European CPI readings.
Based on disagreement among ECB members, we expect a tough debate at next month’s meeting on whether another interest rate hike will be needed in September.
And considering the central bank’s view that inflation risk is still on the upside, the market should not expect any rate cuts soon. Rather, the ECB will wait for clear signs that core inflation has not only peaked but started to fall toward its 2% target.
In our view, the market should have expected higher rates for longer. But it continues to believe that the ECB is overreacting to inflationary pressures, as evidenced by the flattening of the yield curve since the ECB meeting on Thursday.
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