Today, the European Central Bank (ECB) raised its three key policy rates by 50 basis points (bps)—the interest rate on the main refinancing operations, the marginal lending facility, and the deposit facility will be increased to 2.50%, 2.75% and 2.00% respectively. With 250 bps of rate hikes since July, and additional hawkish guidance at this meeting, the ECB’s goal remains one of dampening demand and guarding against the risk of a persistent upward shift in inflation expectations.1

1From today’s meeting: “Rates will still have to rise significantly to a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation,” (to the ECB’s medium-term target of 2%.)

At today’s meeting, the ECB also set out of principles for balance sheet normalization (known as Quantitative Tightening, or QT). It was announced that from March 2023, the asset purchase programme (APP) portfolio will decline by an average of €15bn per month until the end of June. Decisions about further declines will be determined over time. There were no announced changes to the bank’s other lending programs.

Latest staff projections: Stagflationary year-ahead

The ECB published its updated staff projections, including some nuanced GDP growth forecasts:

  • 2022: 3.4% (upward revision from 3.1% in September, and from 2.8% in June)
  • 2023: 0.5% (downward revision from 0.9% in September, and from 2.1% in June)
  • 2024: 1.9% (no revision from 1.9% in September, and from 2.1% in June)
  • 2025: 1.8% (a new annual projection)

The most notable part of the ECB baseline staff projections is the acknowledgment of the immediate risk of recession. A forecast that is now consistent with weak confidence surveys and Purchasing Managers’ Index (PMI) economic activity data. Staff projections see a risk of contraction in both 4Q and 1Q, owing to the energy crisis, weakening global economic activity and tighter financing conditions. However, the ECB expects such recessionary quarters to be relatively short-lived and shallow, and the expectation is for a recovery in subsequent quarters as headwinds fade, allowing annual 2023 growth to be subdued to just 0.5%.

The inflation outlook was, predictably, upwardly revised across the forecast period:

  • 2022: 8.4% (upward revision from 8.1% in September, and from 6.8% in June)
  • 2023: 6.3% (upward revision from 5.5% in September, and from 3.5% in June)
  • 2024: 3.4% (upward revision from 2.3% in September, and from 2.1% in June)
  • 2025: 2.3% (a new annual projection)

According to these projections, inflation will still be above the ECB’s 2% target at the end of their forecast period, implying that further rate hikes will clearly be required.

Hawkish guidance

Today’s hawkish guidance is the result of inflation remaining far too high, and from projections indicating inflation will stay above target for too long. The statement said the ECB Council “judges that interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive.” The term “steady pace” here does not rule-out a further step down to 25 bps, but also allows a possibility of more 50 bps hikes. While the market is currently pricing in a peak terminal rate of just over 3%, the message was clear: Slower (hikes) does not necessarily imply lower (endpoint).

The United States Federal Reserve has also recently slowed the pace of its rate hikes, which has been a short-term buffer to the euro (up 12% since a late September low). This is contributing to tightening financial conditions in Europe, as well as dampening import inflation effects—both welcome developments for the ECB to achieve its goals.

With both annual headline and core inflation remaining near record highs (10.0% and 5.0% respectively), the euro area still needs additional tightening to bring inflation back towards the 2% target. Nonetheless, after a couple more rate hikes, if the economic slowdown persists for longer, or presents a deeper contraction than currently forecast, this may impede the ECB from further hikes, arresting its hiking cycle to a premature end before it has effectively seen inflation return to target.


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