With this vigilance, the main question for the ECB will be whether to go for a preemptive insurance hike or stay put. Market expectations have already tightened the monetary policy stance in recent weeks. Real long-term interest rates, for example, are at levels last seen in the period between 2013 and 2016. It is these market expectations that are likely to shift the needle towards a rate hike. We have been there before – an ECB stressing that not delivering on market expectations would actually ease the monetary policy stance.
A tighter monetary policy stance and creeping inflationary pressure are why we think that a rate hike is almost a done deal. Isabel Schnabel’s comments earlier this week confirmed the direction of travel. In fact, it would probably require another sharp deterioration in economic sentiment for the ECB not to hike. Even if the war in the Middle East were to end tomorrow, the damage to inflation has already been done. Inflation has started – and will continue – to hit the eurozone economy. The only question is whether it will fall in the category of ‘transitory’ or whether supply chain disruptions could create more knock-on effects than ‘only’ on transportation and food prices. Given the 2022 experience, the ECB is likely to opt for an ‘insurance’ rate hike. Not that a rate hike will do a lot to affect inflation expectations, but it would be a symbolic move, stressing the ECB’s determination to act.
What’s even more interesting is what will happen beyond the June meeting. Markets have started to price in a total of three rate hikes. However, as long as fiscal stimulus remains muted, the risk of an outright inflationary spiral remains small, making an aggressive monetary policy reaction to the current energy price shock unlikely. In fact, even if it’s still in the ECB’s institutional memory, the comparison with 2022 doesn’t quite hold: back then, the eurozone economy entered a post-lockdown boom, there was substantial fiscal stimulus, higher inflation rates and a much looser monetary policy stance.
For us, the better reference period for the ECB remains the 2011 experience. Back in 2011, the ECB hiked interest rates – admittedly from slightly lower levels than they are currently – to tackle rising inflationary pressure, only to discover that these rate hikes pushed the eurozone economy further into stagnation. As the ECB had underestimated the adverse effects of the sovereign debt crisis, the 2011 rate hikes were reversed quickly. Underestimating the adverse impact of a shock and focusing too much on rising inflation as a result of higher energy prices? The ECB has been there.
For now, we only see one insurance rate hike in June being used to demonstrate the ECB’s willingness and determination to keep inflation expectations anchored. As long as the bond market is taking over the ECB’s work to tighten the monetary policy stance, governments don’t fuel an inflationary spiral with fiscal stimulus, and sentiment indicators remain weak, it’s hard to imagine that the ECB would really want to fight an exogenous supply shock at the cost of worsening an economic downturn.