The European Central Bank Details Rate Hike Path, Raises 2022 Inflation Forecast

Hawkish Pivot

The European Central Bank is behind its major counterparts in monetary policy normalization, having been surpassed even by the Reserve bank of Australia, which delivered its second straight and largest hike in more than 20 years in June.

The ECB still runs an asset purchases program (APP) and its benchmark interest rate is firmly in negative territory, but has been increasingly hawkish recently, with various officials calling for rate increases and some even talking of aggressive 50 bps moves.

President Ms Lagarde, had rubberstamped the hawkish shift in late-May, saying that she expects the APP "to end very early in the third quarter", which would allow a "rate lift-off" at the July meeting, adding that the bank will likely be in a position to "exit negative interest rates" by the end of Q3. ^[1]

Rate Lift-Off in July

Today, the central kept main interest rates unchanged as expected and although this was looking like it would be a placeholder meeting in preparation of July action, officials actually provided a rather thorough view into their tightening path. ^[2]

Besides announcing the end of the asset purchases program (APP) in July 1, in line with Ms Lagarde's recent comments, the Governing Council also stated its intention to raise interest rates by 25 basis points in the next meeting in July.

Officials went a step further and pointed to more tightening ahead, saying that they expect to raise rates again in September, opening the door to larger adjustments, "if the medium-term inflation outlook persists or deteriorates".

The bank is looking to continue hiking beyond the third quarter, noting as it "anticipates that a gradual but sustained path of further increases in interest rates will be appropriate".

Detailed Policy Outlook

The European Central Bank has had a hard time providing clear communication regarding its intentions and we have often seen leaks, reports and rumors following policy decisions. This is to certain extent reasonable, given the inner workings, structure and competing interest amongst different countries.

Recently however, the bank seems to have improved on this front, on which its US counterpart has done a far superior job. Ms Lagarde had clearly communicated the bank's intentions last month and today's statement laid out a detailed policy normalization path, noting in her press conference that today's decision was "unanimously approved". ^[3]

Furthermore, the announced normalization path appears to have achieved a balancing act between the hawks and the doves. The 25 bps July hike reference is a victory for the doves, whereas the fact that the statement pointed to potentially more aggressive moves in September, may be enough to satisfy the hawkish camp.

However, officials have a tough job ahead as they must cope with the uncertainties of the war in Ukraine, to which the European economy is exposed and could lead to a slowdown, with the bank noting this "continues to weigh on the economy in Europe and beyond".

Surging Inflation & Upgraded Projection

The main reason for the ECB's policy shift towards normalization, is surging inflation, in the aftermath of the pandemic, exacerbated by the war. The latest preliminary data showed that the headline Consumer Price Index surged to a record high of 8.1% in May year-over-year, from the 7.4% final print for April.

Today, the central bank acknowledged that this is a "major challenge for all of us", stressing that it will "make sure that inflation returns to its 2% target over the medium term". It also raised the 2022 Inflation projection to 6.8%, from 5.1% in the March forecast.

Fears of stagflation persist, as energy prices remain high, despite the OPEC+ accelerated output plan, putting upwards pressure on inflation and dampening economic growth, along with supply chain disruptions and the tightening monetary environment.

The bank downgraded its projections today, expecting Eurozone GDP to grow by 2.8% this year, from 3.7% in the March projections.

EUR/USD Reaction

Today's decision sparked volatility and two way action, as it contained many components. On the one hand, the bank offered a tightening path, which went past July. On the other hand, it took off the table larger 50 basis points on the next meeting, but left the door open to such action in September.