The tightening of interest rate is far from over
Higher for longer
Back in autumn we had already argued that the ECB would have to adopt a pronounced hawkish stance if it wanted to bring the inflation rate down to its target level in the medium term. And we pointed to the risk that markets might get it wrong as the necessary consequence was higher rates for longer. However, like most observers, we had somewhat underestimated the Council’s resolve at that early stage of the hiking process. That resolve is now demonstrated by a broad majority of the Council which is by no means prepared to accept a persistent missing of the inflation target and, in view of the latest data, is determined to pursue the course of interest rate tightening vigorously. Financial markets are beginning to realise this, pricing in a terminal rate of 4 per cent and abandoning expectations of an early turn back to easing.
Stubbornly elevated core rate puts pressure on Governing Council to act
Although the headline rate of inflation has declined as energy prices have fallen, the core rate has continued to rise significantly. In September 2022, it was still at 4.8 per cent. In February 2023, Eurostat now measured 5.6 per cent. When the Governing Council meets in a week’s time, it will not only have to digest this new data but will also find a refreshed economic staff projection on the table. In December, the projection for the annual average core rate in 2023 was still 4.2 per cent. This figure will have to be revised upwards, and the trajectory will also not point swiftly downwards as previously hoped. One of the reasons for this is likely to be wage development. In December, the staff had still expected a 5.2 per cent increase for 2023. This forecast could also be in need of correction.
The persistence of inflation is hard to deny
In many euro countries, workers and trade unions are now determined to make up as much as possible for the real wage loss suffered. A wave of strikes is spreading. It is typical of European labour markets, with their long-running collective agreements, that they react with a time lag, so that second-round effects may be delayed but are all the more certain to occur. Workers have borne the brunt of welfare losses due to worsening terms of trade and temporary social policy support measures by governments fading out. Businesses, on the other hand, have managed to maintain or even expand profit margins and pass on cost increases. Historical experience teaches that an inflationary environment leads to sharper distributional struggles and inflation thus threatens to become persistent. In addition, skilled labour is scarce, and the green transition is driving up prices. Making supply chains more resilient is also driving costs up.
Strong reasons for The Governing Council to demonstrate its resolve
Stubbornly elevated inflation rates require interest rates that are perceived by consumers, businesses and financial markets as being imminently restrictive, not at some point in the future. After all, the average household inflation expectation for the next 12 months is almost 5 per cent. Market-based five-year-in-five-year inflation expectations are in danger of becoming unanchored. This is despite the fact that markets are now assuming a terminal rate of 4 per cent. Undershooting these market expectations would be extremely risky; it might be better to even exceed them. The Fed’s recent statements underline the urgency of a determined course, from which the ECB will not be able to detach itself. In our bold scenario, as long as the core inflation rate does not clearly start to decline, further interest rate hikes of 50 basis points are warranted. We can well imagine that a deposit rate of 4 percent will already be reached in June and that the rate – if necessary – will be raised to 4.5 percent by September. In parallel, the hawks will call for an early end to reinvestment of maturing bonds, not only in the APP but also in the PEPP, so that longer-term interest rates also adjust more quickly to the new environment.
Impact lag remains the final argument for a less hawkish course
Even governors typically seen in the dovish camp are now showing openness to a terminal rate of 3.75 or 4 per cent. However, as much of the tightening effect may still be in the pipeline, they believe that the risk of doing too much too fast should be mitigated by considering this the appropriate level for a pause. They can argue that credit is already getting more expensive, lending is losing momentum and housing markets are correcting. And they can argue that it is by no means clear yet that wage increases will be so large as to drive inflation further and that businesses may take cuts in prices and margins in deference to their sales. The less hawkish course would lead to a terminal rate of at least 3.75 per cent, but more likely 4 per cent, by July or September at the latest. Then a prolonged interest rate plateau would follow. Philipp Lane recently put it this way: “It could be quite a long period, a whole series of quarters.” With a lower policy rate, there is much to suggest that the period of unchanged interest rates could last even longer than with a higher policy rate. Hawks do see an even more acute risk: That either the ECB misses its target, or that the Council would have to embark later on another hiking cycle in order to eventually rein in inflation.
Can central banks go bust?
The answer is clear: No, they cannot go bankrupt. In principle, they can carry on even with negative equity as they are always solvent in the currency they issue, no matter what their balance sheet looks like. Still, some worry about the reputation of the central bank and that the trust in the currency might be damaged. And due to the growing interest rate differential between the asset side of their balance sheets, where they hold long-dated low-interest bonds, and the liability side, where they pay interest on deposits to commercial banks, restrictive monetary policy increases the risk of loss.
However, it would be fatal if central banks paid more attention to their earnings situation than to their monetary policy mandate. In the balance sheets for 2022, the euro central banks still get off lightly. Losses can be offset by provisions. In a year’s time, when the balance sheets for 2023 have to be presented, provisions and equity capital will probably have been used up at many euro central banks, so that they will have to book losses carried forward in the following years. For the states as owners, this will mean that they will have to eliminate central bank profits from their financial planning for many years. In some cases, the legal situation could also require the recapitalisation of the national central bank. This may entail a risk to independence. And it may propel the worries of some into a wider concern of the general public about reputation and trust into the Euro and its Central Bank. The more successful the Eurosystem will be in fighting inflation, the easier it will be to fend off these challenges.
Jan F. Kallmorgen: email@example.com | +49 170 200 3366
Michael Best: firstname.lastname@example.org | +49 171 7482878
Martin Wiesmann: email@example.com | +49 172 7504956