John Fahey: Markets soften bets to see further ECB rate hikes amounting to 1% this year

ECB President Christine Lagarde emphasised that the pace of rate hikes will be data dependent.

Last week saw the ECB raise interest rates for the first time since July 2011 and in doing so, bring an end to its negative interest rate policy that has been in place since mid-2014. 

It announced a 50 basis point, or half point, increase to its key interest rates. 

The rate hike was more than the 25 basis point rise the central bank had guided at its previous meeting in June. The ECB stated that its decision to raise rates by more than it had guided was due to its updated assessment of the inflation risks facing the eurozone. 

The other reason it cited was to have time to get approval for its so-called Transmission Protection Instrument, a tool that is designed to prevent unwarranted side-effects on eurozone bond markets as the central bank tightens monetary policy.

In terms of its forward guidance, the ECB is no longer providing any. That is other than that rates will continue to rise at its upcoming meetings. It stated that the front loading of its exit from negative interest rates will allow it to adopt a “meeting-by-meeting” approach to interest rate decisions. 

President Christine Lagarde emphasised that the pace of rate hikes will be data dependent.

There has been a lot of volatility in terms of market rate expectations recently in reaction to central bank newsflow and key data releases. Indeed, immediately following the meeting, the market was pricing in 125 basis points, or 1.25%, of further tightening this year. 

However, futures contracts softened somewhat after the release of weak eurozone manufacturing survey on Friday. Current market pricing is for around 100 basis points, or 1%, of rate hikes over the remaining three ECB meetings this year. Further out, there is a 25 basis point tightening envisaged for 2023. 

The market is expecting that rates will peak at 1.25% by mid-2023, and remain at this level into the end of next year.

These expected levels are well below what is anticipated from some of the other key central banks, which are already well into their rate tightening cycles. In the US, rates are projected to peak at around 3.4% by the end of this year, while the market anticipates the Bank of England’s bank rate could reach a high near to 3% during the first half of next year.

The market is less hawkish on the eurozone rate outlook due to the fact that the ECB has been much slower to hike rates and also because the challenging macro horizon facing the currency bloc could limit the extent to which the ECB will be able to increase rates by. 

The central bank itself noted that economic activity is slowing. It referenced the war in Ukraine, the impact of high inflation on purchasing power, supply constraints and disruptions, and heightened uncertainty as headwinds to growth.

The latest ECB staff projections, which were released at its previous meeting in June, are for the eurozone economy to grow 2.8% this year, slowing to 2.1% in 2023. However, the more recent European Commission forecasts for 2.6% growth in 2022, slowing to 1.4% next year, seem more appropriate given the significant challenges facing the economy.

• John Fahey is senior economist at AIB