Inflation: ECB Playing Catch-Up as Rate-Hike Path Steepens

The European Central Bank remains behind the curve on tackling record euro-zone inflation and will have to act more forcefully than previously envisaged to wrest control of prices, according to a survey of economists.

Despite a surprisingly big increase in interest rates in July, more than two-thirds of respondents say officials have acted too slowly in battling inflation that is just hit 9.1%. They now predict a higher endpoint for the cycle of hikes, reached more quickly and including a 75 basis-point step on Sept. 8.

Deposit-Rate Path

Economists expect quicker hikes, and a higher terminal rate than in the previous poll

The results suggest the ECB will look past the threat of a looming recession in the 19-member euro area to prioritize the struggle with soaring prices. A three-quarter-point hike, now also seen by money markets, would align the ECB more closely with the Federal Reserve, which has already delivered two increases of that magnitude.

“The ECB will continue hiking rates at an accelerated pace and will send a hawkish message,” said Nerijus Maciulis, an economist at Swedbank. “It needs to repair its reputation and be able to claim victory once inflation starts retreating.”

Faster rate increases may offer some support to the euro, which has plunged as the US central bank ramped up borrowing costs. That has made imports, particularly dollar-based commodities, more expensive, adding to a cost-of-living crisis that is weighing on Europe’s economy.

Many analysts surveyed predict gross domestic product will contract for at least two quarters, though more than half do not see the downturn stretching longer than that.

“The ECB will continue to drive a hard line against inflation, despite evidence that growth is slowing,” said Claus Vistesen, an economist at Pantheon Macroeconomics. “We even expect the ECB to outright recognize that the economy is now entering a recession, but that it will continue to hike regardless.”

President Christine Lagarde will present updated forecasts next week highlighting the policy dilemma: While the growth outlook is set to be downgraded, inflation projections will be revised up.

Price gains are seen staying above the 2% target in 2024 — a worrying sign for officials who are closely watching inflation expectations. But the range of predictions is wide, reflecting difficulties in forecasting amid the uncertainty caused by the war in Ukraine.

What Economics Says:

“The tone of discussions surrounding the European Central Bank’s next interest-rate decision on Sept. 8 seems to have shifted. Several prominent members of the Governing Council are pushing for a large rate hike in September, inflation is again beating forecasts and the global monetary policy backdrop has swung more hawkish.”

Policymakers will stress their determination to “continue hiking rates to bring down inflation,” said Carsten Brzeski, an economist at ING. “The unanswered question is still how the ECB’s reaction function will look in what increasingly looks like a severe winter recession.”

The ECB unveiled a tool in July to address potential trouble in bond markets as more highly indebted euro-area members get used to rising borrowing costs. While some officials hope its very existence will soothe investors, most respondents see the Transmission Protection Instrument being activated at some point.

The ECB is also flexibly deploying reinvestments from 1.7 trillion euros ($1.7 trillion) of bonds bought during the pandemic to help struggling nations. Half of the proceeds over the next three months are expected to be invested in Italian debt, with about a third split between Spain, Portugal, and Greece.

Many respondents also expect the Governing Council to discuss shrinking its balance sheet by the end of March 2023, though estimates on when the ECB can begin offloading its roughly 5 trillion euros of bond holdings varied widely. Most do not think it will be able to roll off more than 30%.

Bloomberg

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