FRANKFURT, Germany — The European Central Bank is expected to frontload a series of rate hikes and sacrifice growth in the region due to the rising cost of living which is threatening to surge even higher.
ECB Executive Board Member Isabel Schnabel’s speech in Jackson Hole set the tone for the upcoming policy meeting this week. With inflation in the euro zone projected to rise to at least 10% in the coming months and the risk of consumer prices rocketing higher, a “jumbo” rate hike of 75 basis points on Thursday is certainly a possibility.
“As frontloaded hikes can have a bigger impact on inflation expectations than a more gradual approach, a 75bp move could make sense,” said ECB watcher and Berenberg’s Chief Economist Holger Schmieding in a research note.
“Although it is largely priced in, it could still exacerbate strains in the bond markets.”
The recent halt of gas deliveries to Europe via the Nord Stream 1 pipeline has not only pushed stocks lower and increased the risk of a recession in Europe, it’s also pushed Italian government 10-year yields to 4% — the highest level since mid-June before the ECB announced the creation of an anti-fragmentation tool. High yields for Italy — much higher than those in Germany — mean the government in Rome has to pay more to borrow, exacerbating concerns over its hefty debt pile.
Inflation in the euro zone hit 9.1% in August and with the continued pressure on energy prices it’s expected to reach double-digit levels in the coming months. At the same time the risk of a recession is looming large over the region’s economy as consumers feel the pain and scale back their consumption, and companies struggle with high energy prices.
“While governments will partially ‘foot the bill’, there are limits to what extent the private sector can be shielded from this income shock,” said Dirk Schumacher with Natixis in a research note to clients.
“The drop in consumer confidence to a record low over the last months, indicates that households are aware of these limits with respect to government support. There is also increasing evidence that companies in energy intensive sectors are reducing production.”
Because of the inflation outlook, the ECB is expected to sacrifice growth in order to keep inflation expectations anchored, as this is the bank’s core mandate.
“A key take away from recent comments by ECB officials is that the hiking cycle will be less sensitive to recession than we thought,” said Deutsche Bank’s Chief Economist Mark Wall in a research note.
“We raised our terminal rate forecast by 50bp to 2.5%,” he added. The ECB’s benchmark rate is currently at zero.
The Frankfurt institution believes its “neutral” rate — an optimal level for a steady economy — to be between 1% and 2% and with inflation risk rising the ECB’s Governing Council might need to consider raising rates above that level into tightening territory.
That, of course, also raises the question about quantitative tightening — which is the technical description for shrinking the central bank’s balance sheet. Selling assets has not yet been discussed by the ECB.
“Given the threat to the ECB’s credibility, we also wonder why quantitative tightening is not discussed,” Anatoli Annenkov of Societe Generale, said in a research note. “Not using QT should imply higher rates.”
Correction: This story has been updated to reflect that inflation in the euro zone hit 9.1% in August.
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