Jim Power: Another rate hike is hard to justify amid environment of uncertainty

The ECB are set to meet on Thursday but another hike is unlikely as two wars put pressure on energy markets.

Mon, 23 Oct, 2023 - 02:00

Jim Power

On Thursday, the European Central Bank (ECB) is holding its interest rate meeting in Athens.

Since July 2022, the monetary authority has increased interest rates 10 times by a cumulative 4.5%. By any historical standard, this is a pretty dramatic tightening of monetary policy over such a brief period, notwithstanding the fact that rates were being increased from an abnormally low level. Ahead of the meeting, the interesting question is if the ECB will increase rates again and the nature of the commentary that will accompany whatever decision is taken.

At the best of times, I feel uncomfortable trying to anticipate what any central banker might do, but these are not the best of times. Uncertainty, volatility, and heightened global economic and geopolitical risks are very much the defining feature of the landscape. I would be surprised if the ECB tightened on Thursday and indeed, we are close to, if not at the peak of the interest rate cycle.

The ECB has a mandate to target inflation at 2% or slightly lower. In September, inflation was running at 4.3%, which is the lowest since October 2021.

The headline rate peaked at 10.6% in October of last year. The core rate of inflation, which excludes volatile food and energy prices, is running at 4.5%, which is the lowest level since August 2022.

Importantly, service sector inflation has declined to 4.7% from 5.5% in August. It is clear, that the cumulative interest rate increases seen over the past 15 months is working.

The eurozone economy expanded by just 0.1% in each of the first two quarters, and German growth declined by 0.1% in the first quarter and was flat in the second quarter. Growth in the eurozone is bouncing along the bottom and forward-looking indicators such as the purchasing managers indices are still in contractionary territory.

So, although headline inflation is still well above the 2% or slightly lower target, it is moving in the right direction. In any event it does take a year or more for the full impact of rate tightening to fully feed through the economic system.

Based on current analysis of the eurozone economy and the trajectory of inflation, I could not make an argument for further tightening. I am strengthened in this viewpoint by the very uncertain and dangerous global economic and geopolitical background.

Bond yields everywhere have increased dramatically in recent months, with the US 10-year Treasury yield reaching a 16-year high of just under 5% at the end of last week and the German 10-year yield reaching nearly 3%, which is the highest level since 2011.

Long-term rates are being forced up by a belief that central bank rates will remain higher for longer, or at least that is the perception of financial markets now. Bond yields are the most significant and influential financial market and the sort of spike we have seen in recent months, does pose a significant threat to economic activity over the coming months.

On top of these very risky and volatile financial market conditions, the global geo-political backdrop is becoming scarier by the day.

The Ukraine war has been a considerable source of angst on many distinct levels over the past 18 months, but the latest developments between Israel and Hamas brings the risk to a whole new level.

Oil prices are under pressure again, which is not surprising, given that a third of global crude oil emanates from the Middle East. However, the potential for this conflict to develop into something much more serious for the whole region is very real and the impact on global confidence could be very damaging.

Against a background of such risk and uncertainty, an ECB tightening next Thursday is impossible to justify.

I expect rates to remain on hold, but the monetary authority is still likely to present a bearish tone and stress that the battle to bring inflation under control is ongoing.

The ECB could of course prove me wrong, but another tightening would be a dangerous overkill. I wonder if this time next year, the narrative will have changed, and ‘easing’ will be back in the ECB’s lexicon.