ECB plays for time to ponder first rate rise in a decade

Once bitten, twice shy

The ECB is wary of being accused of mistiming its intervention, or of trying to tackle energy-driven inflation with its policy tools. Under the presidency of Jean-Claude Trichet, in 2011 the ECB lifted borrowing costs in reaction to oil prices and the European debt crisis. With inflation at the time running at less than 2%, that was widely interpreted as a policy mistake. The hikes were soon reversed, eventually taking rates negative in June 2014.

Isabel Schnabel, who sits on the ECB’s Executive Board, last week addressed the accusation of fighting high oil and natural gas prices with interest rates. “Raising rates would not lower energy prices,”² she wrote in a Twitter session. Still, she added, if higher inflation were to undermine expectations, “we may still need to respond, as our mandate is to preserve price stability.”

From an economic perspective, the question is whether the eurozone can withstand monetary policy normalisation while continuing to grow. Economic indicators suggest that the recovery would support a higher cost of borrowing; trade, housing, spending on services, investment and income growth are all positive. Unemployment fell to 7% in December, a two-decade low, while the labour participation rate has reached a record. Gross domestic product is expected to grow by 4% this year, followed by an expansion of 2.7% in 2023, according to a January forecast by the European Commission, the European Union’s executive. We believe that eurozone GDP will expand by 4.3% this year, and another 2.8% in 2023.

The Commission also expects inflation to remain above 3% through September, before falling to 2.1% in the last three months of 2022. The same forecast sees annual inflation under the ECB’s “medium term” target of 2% for 2023. We project eurozone inflation to reach 3.6% by the end of this year.

If inflation does slow over the next few months as supply-chains and shortages are resolved, central bankers may fear choking-off economic growth, making it possible that we may not see the expected rate rises materialise.

The ECB’s next meeting on 10 March will assess new data, as well as its revised economic forecasts, according to Mrs Lagarde.

Sequencing lag

Markets have started pricing a first interest rate hike in June. Still, the ECB cannot begin its rate ‘lift-off’ until it has wound-down its bond market purchases. The ‘pandemic emergency purchase programme’ (PEPP) is scheduled to finish at the end of March with a wider monthly ‘asset purchase programme’ (APP) progressively trimmed through the third quarter.

As a result, we believe that the central bank is more likely to end asset purchases by September, leaving space for a first hike in December. At this stage, against a background of slowing core inflation, we expect the first increase to be 25 basis points (bps), taking the bank’s policy rate from today’s -0.5%, to finish this year at -0.25%.

The ECB’s approach lags monetary policy normalisation at the Bank of England (BoE) and US Federal Reserve (Fed). Last week, the BoE raised interest rates by 25 bps to 0.5%, after a first increase of 0.15 bps at the end of last year. With the Fed scheduled to end its quantitative easing in early March, followed by a rise in interest rates, the US central bank reminded investors that it has room to accelerate policy normalisation even further. We believe that the Fed is poised to make four hikes this year, to reach a benchmark rate of 1.25% by the year end, and eventually a terminal rate of 2.50-2.75%.

While inflation persists in the eurozone, the region’s economies face a different set of challenges. Inflation is not uniformly high across the 19 countries sharing the common currency. Price rises ranged in January from an annualised 3.3% in France to 5.1% in Germany and 12.2% in Lithuania. In addition wage growth is much more modest than in the US and UK, and lower European fiscal stimulus has not driven demand to exceed supply. Excluding energy and food prices, the eurozone’s core inflation fell from 2.6% to 2.3% in January, which is around half of the comparable levels seen in the US and UK.

‘Watching paint dry’

In June 2017, then-Federal Reserve Chair Janet Yellen said that central bank policy normalisation should “be like watching paint dry… just something that runs quietly in the background.”

Nearly five years later with Mrs Yellen at the US Treasury, policy normalisation by the Fed, BoE and ECB have all driven recent market volatility. After a decade of ultra-accommodative monetary policy intensified by pandemic support over the last two years, markets are highly sensitive to the transition to life in a world of lower liquidity.

In this context, investors are repricing the assets and sectors that benefitted the most from the liquidity provided by central banks. Equity investors are naturally focussed on the strength of the economy and corporate earnings, selecting firms that are better positioned to manage the evolution towards higher materials and financial costs. We think these include the industrial, materials, energy and financial sectors. On a geographic basis, we prefer UK and European stocks, which are less threatened by inflation. They offer greater opportunities for earnings growth while remaining relatively cheap compared with US markets, where until recently, indices’ larger share of technology stocks benefitted from low rates.

It is worth repeating that in the past, equity markets have experienced periods of volatility in the early stages of monetary policy normalisation, before recovering. We remain underweight investment grade fixed income, given the potential for higher rates and wider corporate spreads. We also maintain a preference for Chinese government bonds in local currency as a portfolio diversifier, as well as high yield and emerging market debt in US dollars. Chinese inflation fell to an annualised rate of 1.5% in December last year, compared with 2.3% a month earlier.

In currency markets, we expect the euro to weaken against the US dollar and sterling, and forecast a year-end EURUSD exchange rate of 1.09. As more central banks, including the ECB, tighten monetary policy, global liquidity will continue to decline. For the EURUSD this matters more than any policy lag between the ECB and Fed. If the ECB’s deposit rate turns positive, from its current level of -0.5 basis points, debt may flow back into eurozone fixed income, offering some support to the single currency. Still, such flows are unlikely to be sizeable because the region’s yield will remain low relative to other markets.

¹ https://www.ecb.europa.eu/press/pressconf/2022/html/ecb.is220203~ca7001dec0.en.html
² https://twitter.com/ecb/status/1491427015882571776

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