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ECB Preview: Keep calm and breath
Summary: The European Central Bank (ECB) cannot blink at that stage. It needs to deliver a 50-basis point interest rate hike at tomorrow’s meeting. Anything else would risk turning into a communication disaster. However, the pace of monetary policy is highly uncertain in the medium-term due to growth concerns and the ongoing market turmoil.
Baseline: Expect a 50-basis point interest hike at 3 % and no real guidance on the scope of interest rate hike after that.
We don’t think the Silicon Valley Bank’s failure and the current market turmoil will have a direct impact on tomorrow’s ECB rate decision. The ECB cannot blink at that stage. It needs to deliver a 50-basis point interest hike, at 3 %, to show determination to fight high inflation. This is a matter of credibility. Inflation is more entrenched than initially anticipated. Yesterday, France's Consumer Price Index was revised higher for February, at 6.3 % year-over-year - this shows that the inflation headache is here. The main drivers of inflation have changed. In 2022, energy was the main contributor to higher prices. In 2023, it will be replaced by food and profit. An internal ECB presentation, unavailable to the public, reportedly shows “that company profit margins have been increasing rather than shrinking, as might be expected when input costs rise so sharply”. This means that corporate profits are now driving inflation more than wages. Higher inflation for longer plays in favor of a continued hiking cycle.
However, the uncertainty regarding the magnitude of monetary policy tightening beyond the March meeting is unusually high. This is partially explained by growth concerns. The euro area Q4 2022 GDP was revised down, from +0.11% to -0.03% QoQ, mostly due to a sharp revision of the Irish Q4 GDP (from +3.5% to only +0.3% QoQ). On top of that, credit data will likely be weak. In the coming months, expect a big battle of wills brewing between hawks and doves. Monetary policy uncertainty is also explained by financial instability risk. It is premature to know how the ongoing market turmoil will unfold. But this is getting clear that whilst hiking the ECB will need to ensure European banks continue to be well capitalized and have enough liquidity buffers. As rates have gone and continue to go up, high quality liquid assets portfolios have decreased in value. Fortunately, the ECB has the tools to intervene preemptively. The central bank can provide swap lines to banks or decide not to end up TLTROs, for instance. This should be enough to contain liquidity risk.
The high uncertainty in monetary policy is reflected in market expectations of terminal rate. Last week, the terminal rate was hovering at 4 %. It is now down below 3.75 % for the first time since 17 February (mostly because of the ongoing market stress and the potential ripple effects on growth). In our view, the ECB will probably not provide much guidance on the scope of interest rate hike beyond the March meeting. This is the wisest thing to do. They will reaffirm that monetary policy will remain data dependent. It will evolve depending on inflation data, the range of sentiment indices (PMI), the new editions of the ECB surveys (the Corporate Telephone Survey, the Consumer Expectations Surveys, the Survey of Professional Forecasters etc.), the incoming data on credit and bank lending rates and the updated information on unemployment and wage dynamics. The evolution of market stress and financial conditions will also be at the center of interest, at least in the short-term.
Despite the market turmoil, market stress is still contained in the eurozone. The ECB systemic risk index is far from the risk area, currently at 0.24.