Hike and then?: Five questions for the ECB

The European Central Bank looks set to pull the rate-hike trigger on Thursday, but what it will do after July is less certain and financial markets are craving some guidance.

Euro zone interest rates have risen 400 basis points in the last year to 3.5 per cent, their highest in 22 years, and are now close to peaking as headline inflation cools and the economy weakens.

“The difference (from past meetings) is that until now they’ve given at least quite precise guidance vis-a-vis the next meeting,” said Barclays head of European economics research Silvia Ardagna. “And we expect that to become more loose.”

Here are five key questions for markets.

1/ How much will the ECB hike rates?

A quarter percentage point increase to 3.75 per cent is priced in by markets and forecast by economists.

Headline inflation is cooling but remains high enough to justify a modest increase. The ECB has flagged a July move.

“The ECB will hike again and anything else would be a major surprise,” said RBC Capital Markets global macro strategist Peter Schaffrik.

2/ What signals is the ECB likely to send about future policy?

Market consensus for one more hike after July is no longer rock solid after some ECB hawks suggested that a September rise is not certain, so the ECB could turn more cautious in its signalling, while confirming it will be data dependent.

“(ECB President Christine) Lagarde will stress uncertainty and conditionality (when and if she mentions further tightening),” said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors.

Some analysts expect the ECB to pause in September, when updated staff forecasts will give it an opportunity to signal that inflation is set to reach its 2 per cent target.

They added that they wouldn’t be surprised if the ECB paused then and hiked later if needed, as the US Federal Reserve has done. Money markets price in one more hike after July, suggesting rates will peak at around 4 per cent.

3/ When does the ECB expect core inflation to fall?

While headline inflation fell for a third straight month in June, so-called core prices, such as those for services, have risen stubbornly and are not expected to relent soon.

Core inflation, seen as a better gauge of the underlying trend, only edged lower to 6.8 per cent from 6.9 per cent – far from the sustained drop rate-setters want to see.

ECB chief Lagarde will likely be pressed on this question but may not give too much away before September’s fresh economic projections.

“Underlying inflation will be very, very slow to come down so this is a worry for the ECB,” said UBS chief European economist Reinhard Cluse, noting a tight labour market and wage pressures.

4/ What does a weakening economy mean for policy?

Well, rate-setters have reiterated that the main focus remains inflation, even if monetary tightening hurts the economy.

“I think (the weakening of the economy) will have minimal impact on monetary policy,” said Ruben Segura-Cayuela, Europe economist at BofA. “What matters for the September meeting will be core inflation.”

Still, slowing growth could strengthen the hands of doves. Euro zone business activity stalled in June as a manufacturing recession deepened and a previously resilient services sector barely grew.

BofA reckons the ECB’s forecasts are too optimistic; Barclays expects a stagnation for several quarters starting from the second half of 2023.

5/ What impact is tighter policy having on financing conditions?

Bank lending data suggests the steepest surge in borrowing costs in the ECB’s history has started to take a toll on credit conditions and latest numbers on July 25 are in focus.

The ECB’s chief economist Philip Lane says loan volumes have weakened sharply and that this may generate a “substantial” decline in economic output.

This dovish message, if reinforced by latest bank lending data, may fuel speculation that rates are close to peaking.

“The peak impact of tightening financing conditions is going to be at the end of this year and the first half of 2024. So a lot of the effect still has to come,” said BofA’s Segura-Cayuela.