June ECB meeting: 25 bps as expected, but stagflation risks are rising

Today the European Central Bank (ECB) again raised its three key policy rates by 25 bps—the second occasion it has hiked by such an increment in a row. The interest rate on the main refinancing operations, and the marginal lending facility, and the deposit facility will be increased to 4.00%, 4.25% and 3.50% respectively, with effect from June 21, 2023.

Today’s statement opened with a firm acknowledgment that “inflation is projected to remain too high for too long.” ECB President Christine Lagarde stated that inflation risks remain elevated due to recent wage agreements in some euro-area countries, as higher wages and hours worked without significant increases in output points to euro-area productivity challenges. At 6.1%, euro zone inflation remains far too high, stemming from such increased wage demands and tight labor market conditions, and is still projected to stay above target beyond 2025. At the press conference, President Lagarde stated that “we are not at the destination” and “we have more ground to cover.” With inflation projected to be still above the ECB’s 2% target at the end of their forecast period, a further rate hike will likely still be required at, and perhaps beyond, the next policy meeting on July 27.

No rate surprise

Despite recent economic weakness and recessionary reports within Germany’s latest economic data, expectations for a 25 bps rate hike had been firmly established following the early May ECB meeting.

Today’s rate move now accumulates to 400 bps of rate hikes since July 2022. Amidst signs of economic weakness and stubbornly elevated inflation, the ECB reiterated its reliance on a data-dependent approach to any future hikes, stating “Interest rate decisions will continue to be based on its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation.”

Balance sheet operations and liquidity backstops

In terms of ECB balance sheet normalization (Quantitative Tightening, or QT), the Asset Purchase Programme (APP) remains set to allow the run-off of assets, with the portfolio “declining at a measured and predictable pace.” The decline will be by €15 billion per month on average until the end of June 2023, and reinvestments under the APP will discontinue as of July 2023. The ECB confirmed that it will reinvest the principal from maturing securities from the Pandemic Emergency Purchase Programme (PEPP) through at least 2024.

Latest staff projections: stagflation risks rising

The ECB published its updated staff projections of GDP growth:

• 2023: 0.9% (downward revision from 1.0% in March, but up from 0.5% in December).
• 2024: 1.5% (downward revision from 1.6 in March, and 1.9% in December).
• 2025: 1.6% (no revision from 1.6 in March, but down from 1.8% in December).

The inflation outlook showed a mild set-back across the forecast period:

• 2023: 5.4% (upward revision from 5.3 in March, but down from 6.3% in December).
• 2024: 3.0% (upward revision from 2.9% in March, but down from 3.4% in December).
• 2025: 2.2% (upward revision from 2.1% in March, but down from 2.3% in December).

Notably, ECB baseline staff projections indicated a modest downward revision to 2023 and 2024 growth, while revising up their inflation forecasts, especially for 2024 and 2025. The growth outlook is consistent with recent weakness in confidence surveys (the manufacturing PMI and unexpected weakness in Germany’s factory orders). As the 2024 inflation projection has gone up, not down, it’s more likely that the July rate decision will be another 25 bps hike, absent a bigger downside surprise in core inflation and/or deepening real economic weakness.

Euro-area sovereign yields and the euro immediately rose on today’s rate decision, as the new economic projections, as well as hawkish Q&A responses from President Lagarde, further solidify expectations for additional rate hikes. The euro, up 13% from a late September low, has been riding a wave of momentum ever since the Federal Reserve began slowing the pace of its rate hikes in late 2022 (and eventually instituting a pause yesterday). The strength of the Euro, as well as higher intertest rates, are contributing to tightening financial conditions in Europe, as well as dampening import inflation effects— both welcome developments for the ECB to achieve its goals.

While annual headline is estimated for May to have slowed to 6.1% from its record high of 10.6% last October, core inflation for May is expected to be 5.3% and could be just at the very beginning of the sought-after abatement. Consequently, the euro-area still requires additional tightening to bring inflation back towards the 2% target. Nonetheless, if an economic slowdown deepens, or systemic issues disrupt monetary policy transmission, this may impede the ECB from further hikes, prematurely halting its hiking cycle.