The European Central Bank promises first rate hike in 11 years 

Global Perspective

June 10, 2022

Executive summary

The European Central Bank (ECB) decided to end net asset purchases and promised a rate hike next month. The Russian invasion of Ukraine is taking a toll on European economies, inflation outlook worsened, and economic slowdown became more visible in ECB’s projections. The Euro is on a path to parity with the U.S. dollar as we expect the ECB to stay accommodative for longer than the consensus estimates.

What happened

The European Central Bank (ECB) joined global central bank peers in tightening financial conditions as it announced ending its quantitative easing (QE) asset purchase program. While keeping monetary policy rates unchanged, the ECB telegraphed a 0.25% hike in July. The ECB hinted another 0.25% hike in September, and kept the door open for 0.5% increases if inflation remains persistently high. The guidance beyond September is murky in order to maintain optionality with a data-dependent approach. 

The ECB accepts inflation will remain undesirably high, the current reading at 8.1% annually with the full year 2022 inflation assumption at 6.8%, followed by a decline to 3.5% in 2023. This is still much higher than the 2% inflation target. The ECB's economic growth rate assumption was downgraded to 2.8% for 2022, with further downward revisions likely as it is still above consensus. Russia’s invasion of Ukraine is a significant headwind for European economies, especially for travel-oriented Mediterranean countries since minimal Russian tourist activity is expected. Energy and industrial material deficit countries like Germany or the Netherlands will also have difficulty locating new energy suppliers, creating new bottlenecks for already-strained European production lines.  

The ECB is balancing between fighting inflation and maintaining stability in the periphery economies, like Greece and Italy, as rising rates will put funding pressures in those vulnerable economies. The ECB plans to use the Pandemic Emergency Purchase Program (PEPP) to mitigate dislocations in Eurozone periphery country bond markets. The central bank has been working with the region's banks for Targeted Long-Term Refinancing Operations (TLTRO). This is a key funding source for banks, and with European rates rising slower than global peers, the availability of funding via this facility is critical for the profitability of European banks.

Our take

Eurozone inflation is high but still below the historical 2% trend line
The current president of the ECB, Christine Lagarde, is the fourth ECB president since 1998. The first two, Wim Duisenberg and Jean Claude Trichet, finished their terms by staying very close to the ECB's 2% inflation target. The Eurozone faced deflation after the global financial crisis and the subsequent European sovereign debt crisis, leading to a 7% gap in inflation during Mario Draghi's presidency. Low inflation persisted during Christine Lagarde's first year, and the COVID-19 induced recession worsened the issue even worse.             

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