Euro Policy Brief: Victory can not be declared

Done deal for June

In contrast to the Fed’s Open Market Committee, the Governing Council of the ECB is not considering an interest rate pause in June. It is rightly expected to raise its key interest rate, the deposit rate, by 25 basis points to 3.5 per cent. This is partly because the ECB is still lagging behind the Fed in the hike cycle. But above all, the Governing Council wants to be true to its promise not to end its cycle of hikes until it sees a sustained decline in the core inflation rate. And Christine Lagarde has clearly stated that this is not yet the case with the first dip in the core inflation rate in May.


The Council will also decide on the already envisaged waiver of reinvestment of maturing bonds in the APP portfolio. This is based on the expectation that the financial markets will be able to absorb the bond volume of around €150 billion maturing between July and December. The moderate level of market interest rates for longer-dated triple-A bonds strengthens the Council in this view. The total volume of the

Eurosystem’s asset portfolio across all programmes will thus shrink to around €4.7 trillion by the end of the year.


Taking a break in the heat of summer?

Italy’s outgoing central bank governor Ignazio Visco has long argued that one should pause at a certain point because monetary tightening only gradually transmits to financing conditions, the real economy and inflation. When, if not in the 40-degree heat of late July, would be the right time to rest?


Economic arguments to make the case for pausing are numerous: Financing conditions for corporates have tightened and the demand for credit has declined. Investments are being postponed because they have to be recalculated at higher interest rates. Consumers are paying more attention to price levels in their consumption behaviour and the economy is weakening. Germany has even slipped from stagnation into recession. In addition, contrary to all forecasts, the price level on the global energy and commodity markets has fallen significantly, which will also eat into the core rate, because energy and commodities are in everything, even in services.


But the hawks in the Council will equally not be short of arguments in July. Just look at what’s happening on Europe’s beaches. They are overcrowded and everything has become damn expensive, the hotels, the holiday flats, the train rides, the car rentals, let’s not talk about the restaurants. Our job is far from done.


The rationality behind the hawkish position goes like this: Only if we reach the appropriate terminal rate as soon as possible do we have a chance of putting inflation on a sustained downward path that can take us back to the target, 2 per cent inflation. If we pause too soon, inflation will become more persistent forcing us to tighten the screws later in order not to jeopardise our credibility.

How will this turn out in July? Eurostat’s flash estimate for July inflation will not be available when the Governing Council meets on 27 July. Only the June figures will be on the table, July will still be subject to speculation. If the core rate fell again by 0.3 points in June, this would be water on the doves’ mill. If, on the other hand, it falls less, the hawks would offer to consider pausing in September after an increase in July to get the majority on their side. Hence, as things stand, we see a 60 percent probability for 25 basis points in July and a 40 percent probability for a pause in the summer heat.


Will the plateau be reached in September?

Tactically, July and September are closely related. If another increase follows in July, it becomes less likely in September. If it does not come, the more likely it is that a final step will be taken in September. From today’s perspective, we would expect a level of 3.75 per cent in the core rate in September with a 70 per cent probability either way. There is a 20 per cent probability that only 3.5 per cent will be reached and there remains a 10 per cent probability that the Governing Council will venture up to 4 per cent.


But how the picture will actually look in September depends on many factors. We would expect the global energy and commodity markets to pick up and financing conditions to tighten only moderately. We would not expect the whole of Europe to slide into recession, nor would we expect a roaring autumn recovery. A further decline in the core inflation rate during the summer to a level between 4.5 and 5 per cent may well be in the cards, whilst still considerable wage dynamics will emerge for 2024. What will the ECB staff make of all this in its September projection? Will it concede that the decline in inflation rates may not be a linear process leading straight to the destination?


Does the targeted strategy lead back to the goal?

The Governing Council has communicated quite precisely how it envisions the further strategy. It deems it necessary to hold the interest rate level reached in September for a longer period of time. Behind this lies the fear that, as in any proper chart, resistance zones will have to be overcome on the downward path of the inflation rate. Where these resistance zones will be met will be largely driven by future wage dynamics.


There are two undeniable reasons to expect continuously stronger wage dynamics in the years to come. On the one hand, employees will try to make up for their real wage losses. Secondly, throughout Europe the baby boomer generation is retiring until the end of the decade, which will lead to shortages in the labour market at all ends. The resulting wage dynamics will force businesses to continuously adjust prices. We see the resistance zone in the price level between 4 and 3 per cent. And we think it is quite conceivable that the ECB will have to resign itself to an inflation rate close to 3 per cent in the medium term, because 2 per cent will only be achievable at the price of a sustained recession.


Sovereign debt may become an issue again

This inflation scenario implies that although the Governing Council may consider cutting rates again at some point, it will not be able to cut rates as much as forecasters and traders expect. Markets might be able to cope with it and banks might make money from it, but what about the highly indebted countries in Europe?


Step by step, France has joined this club and increased its debt to 110 per cent of GDP. The European Commission warns that the country will not succeed in reducing its debt level without adjusting its financial planning. Finance Minister Le Maire is trying to find ways to make savings in the budget. This is a difficult exercise, because President Macron tends to smother political problems with money.


It may prove illusory to expect salvation from inflation. True, nominal GDP rises with inflation and tax revenues increase. But the costs of government projects and staff are also mounting, and above all, interest expenditures are on the rise.


The French Finance Ministry forecasts that France’s annual debt servicing costs will increase from the current €40 billion to €70 billion in 2027. The longer the ECB keeps interest rates high, the more the financing costs of the states will be burdened by the higher interest rates. This applies to all euro countries, but it will hurt the highly indebted ones the most.


So far, the markets seem to be rather unimpressed. The Italian spread has even fallen to its lowest level in a year at around 170 basis points. Although much lower, the French spread is showing nervous swings and recently exceeded 50 basis points again.


In a higher-for-longer interest rate scenario, governments have to move more decisively toward a fiscal consolidation path. Otherwise, they could manoeuvre the ECB Governing Council into the awkward position of having to choose between financial stability and price stability.


Michael Best and Martin Wiesmann, BGA Partners