March ECB meeting: A dilemma solved for now

As financial stresses rapidly shifted over to Europe this week, with concerns about Credit Suisse (CS) accelerating sharply and spilling over into the broader market, there were rising expectations that the European Central Bank (ECB) would pause its rate hiking cycle in favor of further tightening of its policy stance. Instead, and in a show of reasonable strength, the ECB again raised its three key policy rates by 50 basis points (bps) for the third time in a row. Accordingly, the interest rate on the main refinancing operations, the marginal lending facility, and the deposit facility will be increased to 3.50%, 3.75% and 3.00% respectively, with effect from March 22, 2023.

Given the recent market volatility following banking concerns in the U.S. and Switzerland, ECB President Lagarde underscored the view that euro area banks are much stronger than during previous crises and stated that “the euro area banking sector is resilient, with strong capital and liquidity positions.” In addition to this reassurance, the ECB “stands ready to adjust all of its instruments within its mandate... to preserve the smooth functioning of monetary policy transmission.”

Key central bank policy interest rates
U.S. Federal Reserve, Bank of England, European Central Bank, 2000–present

Pre-committed rate move fulfilled

Up until last week, investor expectations for today’s hike had been firmly established at 50 bps after the ECB pre-announced its commitment to such a hike at its early February meeting. However, due to recent volatility stemming from U.S. regional bank failures, and issues with Swiss banking giant Credit Suisse and the Swiss National Bank’s (SNB) response of liquidity provision, market expectations diminished to 25 bps.

However, the recent SNB policy response to provide CHF50bn in liquidity to alleviate localized banking concerns appears to have settled investor nerves, giving the ECB the space to remain focused on delivering price stability. And indeed, with core inflation still yet to peak, there is clear need for further policy tightening. In response to a question about the apparent trade-off between price stability and financial stability, President Lagarde responded that there is no trade-off, noting that the ECB price stability mandate is likely best fulfilled via policy interest rates, while systemic risks are felt to be better addressed through targeted liquidity provision and balance sheet operations.

Today’s rate decision now accumulates to 350 bps of rate hikes since July 2022. From here, however, ECB policy will be more data-dependent, influenced by not just the inflation and labor market data, but also how recent banking crises evolve and spill over to the broader market. At this stage, financial markets are pricing in a peak ECB deposit rate of 3.25%, which is just one quarter-point above where it stands after today’s hike.

Balance sheet operations and liquidity backstops

As well as reiterating the availability of their existing liquidity provisions, many investors had expected, in response to the recent market turmoil, the ECB to announce new liquidity provisions. That proved incorrect, with Lagarde simply restating that the ECB “stand ready to respond as necessary to preserve price stability and financial stability in the euro area.” In fact, the ECB moved forward with planned balance sheet normalization (QT) unhindered, stating that “the portfolio is declining at a measured and predictable pace,” and is expected to amount to €15 billion per month on average until the end of June 2023.

Latest staff projections: Growth pulled forward as inflation slows

The ECB published its updated staff projections of GDP growth and euro-area inflation, but did not take account of recent liquidity concerns in U.S. and Swiss banking sectors. Consequently, there is a lot of uncertainty about their validity and would be subject to change should market and liquidity conditions deteriorate further.

• 2023: 1.0% (upward revision from 0.5% in December, and from 0.9% in September).
• 2024: 1.6% (downward revision from 1.9% in December, and from 1.9% in September).
• 2025: 1.6% (downward revision from 1.8% in December).

The most notable part of the ECB baseline staff projections is the upward revision to 2023 growth in lieu of growth in subsequent years. This is consistent with recent recoveries in confidence surveys and composite PMI economic activity data. Specifically emphasized was energy price risk, stemming from the Ukraine war and China’s re-opening. Potential deflationary growth risks could also arise from tighter financial conditions, and current global banking risks and market volatility, especially if these were to spread contagion to the euro area banking system.

The inflation outlook reflected some progress across the forecast period:

• 2023: 5.3% (downward revision from 6.3% in December, and from 5.5% in September).
• 2024: 2.9% (downward revision from 3.4% in December, and from 2.3% in September).
• 2025: 2.1% (downward revision from 2.3% in December).

Today’s statement opened with a firm acknowledgment that “inflation is projected to remain too high for too long.” As inflation is projected to be still above the ECB’s 2% target at the end of their forecast period, this implies that a further rate hike will likely still be required, at and possibly beyond the next policy meeting on May 4.