European Central Bank keeps door open for further rate hikes
The ECB has entered the final phase of its rate hike cycle. As expected, the central bank raised its key interest rates by 25 basis points, bringing the deposit rate to 3.25%.
Since last July, ECB has raised rates by a total of 375 basis points at every single monetary policy meeting. This is by far the most aggressive monetary tightening cycle since the start of monetary union.
Today’s hike, while the seventh in a row, is the smallest in the current cycle, suggesting that ECB has entered the final phase of this tightening cycle.
While recent data have confirmed that underlying inflationary pressures are stronger than expected, weak credit growth and the latest Bank Lending Survey results suggest that the rate hikes to date are leaving a significant mark on the financing of the economy.
Or as the ECB unsurprisingly put it on May 4 for all Star Wars fans, „The rate hikes so far are having a significant impact on financing and monetary conditions in the euro area, while the lags and strength of the transmission to the real economy remain uncertain.”
At the same time, today’s decision was not just a dovish turn of events, but a good European compromise. The fact that ECB has de facto announced that reinvestment under the asset purchase programme (APP) will stop in July seems to be leverage for the hawks to agree to a 25 basis point hike instead of a 50 basis point hike.
According to ECB President Lagarde, the cessation of APP reinvestment would be equivalent to a monthly reduction of the portfolio by an average of EUR 25 billion.
What will happen next with ECB?
The press conference made it clear that ECB ‘s work is not over. The key phrase was probably that „the inflation outlook remains too high and too long.”
Lagarde had some difficulty signalling whether today’s decision was „dovish” or „hawkish” as she reiterated that more steps were needed and that today’s decision was not a pause.
The longer the press conference went on, the more Lagarde seemed to stress the need for more rate hikes and sounded increasingly hawkish.
To be honest, what started as a clear message of a meeting-by-meeting approach and data dependence ended up with more questions than answers. Perhaps this was just a sign that the ECB is increasingly divided on what to do next.
Press conference aside, it will be difficult for ECB to return to rate hikes of 50 basis points in the current macroeconomic environment with the lagged effects of previous rate hikes, turmoil in the banking sector, and subdued growth but still stubborn inflation.
In this baseline scenario, it will be equally difficult to raise rates more than once or at most twice. Rather, there is a high risk that any further rate hike could prove to be a policy mistake in retrospect.
Instead, the next compromise between the doves and the hawks will likely be to keep rates higher for longer after another rate hike in June. This would buy ECB time to see how the previous tightening fully plays out.
The decision to halt reinvestments from APP starting in July also points in this direction.
All in all, with today’s decision, the ECB has clearly entered the final phase of its tightening cycle, and the peak in interest rates may be closer than ECB President Lagarde wanted the markets to believe at the press conference.