May ECB meeting: Hawkish step down, and no pause ahead

Today, the European Central Bank (ECB) raised its three key policy rates for the seventh consecutive time, opting to step-down the increment to 25 basis points (bps). The interest rate on the main refinancing operations, the marginal lending facility, and the deposit facility will be increased to 3.75%, 4.00% and 3.00% respectively.

With 375 bps of rate hikes since last July’s lift-off, and inflation measures still remaining far too high, the ECB’s goal remains one of dampening demand, tightening financial conditions, and guarding against the risk of a persistent upward shift in inflation expectations. It also stated that “future decisions” will ensure that the policy rates “will be brought to levels sufficiently restrictive to achieve a timely return of inflation to the 2% medium-term target”—a clear demonstration that the ECB believes that policy is not yet at a sufficiently restrictive level.

The ECB also confirmed that balance sheet normalization (known as Quantitative Tightening, or QT) will continue “at a measured and predictable pace.” The asset purchase programme (APP) portfolio will continue to decline by an average of €15bn per month until the end of June, but the ECB expects to discontinue the reinvestments under the APP as of July 2023. This is a hawkish policy confirmation, especially given recent global banking stresses. There also was no preemptive action announced to address the approaching June repayment of TLTRO bank term funding, which could inadvertently add to existing global bank stress.

No forthcoming pause

At today’s press conference, ECB President Lagarde removed any doubt about a future pause in rate hikes by stating multiple times that “we are not pausing” and “we have more ground to cover.” Lagarde refused to be drawn about “the destination,” or where on “the journey” of rate hikes she believes we are, stating simply “this is a journey and we have not arrived yet.” The latest economic data available also suggests that indicators of underlying inflation remain too high, which further explains the ECB’s hawkish tone, acceleration of QT, and their definitive declaration of no forthcoming pause in its rate hikes.

High inflation vs. dampening credit

While headline inflation had been steadily declining since its October 2022 peak, April’s reported inflation figure showed a modest uptick to 7.0%. And despite the extremely modest decline in the ECB’s preferred inflation measure (Core MUICP) in April, it too remains well above target levels at 5.6%. Inflation is still being affected by gradual pass-throughs of prior energy price increases and supply bottlenecks, albeit now to a lesser degree. Services are also contributing, driven by a tailwind from pent- up demand after the reopening of the economy, and by rising wages.

Today’s incremental decrease in the pace of tightening, mirroring the Federal Reserve and other central banks’ slowing of rate hikes, comes amid a hazardous inflation backdrop coupled with increasing concerns around tightening financial conditions in bank lending and credit. Earlier this week the ECB released its own quarterly bank lending survey showing that business demand for enterprise loans had fallen to its lowest level since the Global Financial Crisis—suggesting that the increases in the policy rates since last July are taking effect on credit conditions in the real economy.

Eurozone inflation
Year-over-year % change, 2004–present

Eurozone business loan demand
Level, 2003–present

Implications

Policy rate hikes, and their resultant tightening of credit conditions, have lagged effects on economic activity and inflation, and can be expected to continue in the coming months and quarters. This was explicitly acknowledged in today’s press release, “the past rate increases are being transmitted forcefully to euro area financing and monetary conditions, while the lags and strength of transmission to the real economy remain uncertain.”

Such uncertainty around policy transmission potency and timing confirms that the ECB “will continue to follow a data-dependent approach to determining the appropriate level and duration of restriction.” Provided the euro-area does not suddenly enter a deep recession, and global banking stress remain localized and contained, further rate hikes together with a persistent restrictive stance should be expected for the foreseeable future.

As future rate hikes have been all but affirmed, the ECB has removed any doubt of its commitment to the price stability mandate. President Lagarde affirmed her belief that the European banking system remains resilient and recent bank stresses were idiosyncratic rather than systemic.

Although the ECB matched the incremental rate rise of the Federal Reserve, raising policy rates just 25 bps, the more hawkish tone and ruling out of a pause by the ECB will likely continue to provide a tailwind to the euro, which is up over 15% since its late September low. This appreciation will continue to contribute to tightening financial conditions in Europe, as well as dampening import inflation effects—both welcome developments for the ECB to achieve its inflation goals.

Economic uncertainty remains elevated for the region, and policymakers must surmount a complex balancing act between weak growth, persistent inflation, banking stresses and external international shocks. Eurostat’s preliminary flash estimate showed that the euro-area economy grew by 0.1% in 1Q23. While the immediate risk of recession appears to have been avoided, downside growth risks remain. If the current economic slowdown does later result in recession, or global banking stress further proliferates, this could impede the ECB in its hiking cycle before it has effectively seen inflation return to target.