ECB opens door to possible rate hike in 2022

At last week’s meeting of the European Central Bank’s governing council, policy members finally acknowledged mounting inflation risks and even opened the door for a possible rate hike later this year.  This marks a significant policy shift for one of the world’s most dovish central banks, who has long argued that high inflation will fact back below its 2 per cent target on its own later this year.  In fact, going into the event, the broad consensus was for the ECB to reference the upside risks to inflation while at the same time pushing back on market expectations for interest rate hikes.

A string of record high inflation readings, has however challenged the ECB narrative that other central banks have abandoned months ago.  In fact, a few days before the meeting, inflation in the Euro Area was reported to have surged to a record 5.1 per cent in January, against markets expectation for a drop to 4.4 per cent.  While about half of this was due to double-digit rises in energy costs, price pressures were seen broadening, with the cost of six out of 10 items in the based used to calculate inflation, rising over the past year.

This led the committee to agree that president Christine Lagarde should use the press conference after their Thursday meeting to signal a likely turnaround in monetary policy.  The best way to do this, was to stop dismissing the possibility of a rate rise this year.

The second factor behind the central bank’s policy shift was the rapid rebound of the labour market from the pandemic.  This was driven home for ECB policymakers on Tuesday when the Eurostat said eurozone unemployment had fallen to a record low of 7 per cent, due in large part to a drop in joblessness among young people to an all-time low of 14.9 per cent.

The final factor convincing the remaining doves on the ECB council to rethink their position came when US Federal Reseve chairman Jerome Powell sparked a stock market sell-off the week before, by refusing to rule out more aggressive interest rate rises this year than markets had expected.  Furthermore, all the signs pointed to the Bank of England raising rates for a second time in three months on Thursday – as it duly did.

The reaction on the market was quite fierce and market moves were unusually large.  Following the meeting, money markets are now pricing 50 basis points of hikes from the central bank this year, compared to 28 basis points before the meeting.  Such a move would be enough to bring the deposit rate out of negative territory.  The euro also firmed against the dollar to its highest level this year, while the 2-year German Bund yield spiked sharply to levels last seen in 2015.   

During the press conference, Lagarde, however, insisted that the sequence of the ECB’s future policy moves will not change.  This means that asset purchases, which were originally set to run indefinitely, will now have to end before borrowing costs may be increased.  She indicated the March meeting to be crucial in this respect, as the new economic projections could provide the justification for any policy move.  A first step is likely to be an acceleration in winding down bond purchases, which are now set to be reduced in several steps to €20 billion a month by the fourth quarter.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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