ECB inches nearer to the interest-rate summit

The European Central Bank will almost certainly implement the eighth successive increase in its official deposit rate on Thursday, this time by 25 basis points to 3.5 percent. The interesting bit will be whether it signals it might be ready to at least start thinking about thinking about a pause. Given a welcome downturn in inflation recently and signs that the euro-zone economy is flatlining at best, a hint that rate hikes are no longer automatic at every meeting would be prudent.

It should have some help from the Federal Reserve, which is widely expected to pause when it meets Wednesday. All but one of of 66 Bloomberg survey participants expect the Fed to stick at 5.25 percent. There’s a similar consensus for the ECB decision, with 37 of 38 respondents anticipating a quarter-point increase. The futures market suggests an additional 25 basis points will follow in July — but that might change if ECB President Christine Lagarde is anything other than implacably hawkish this week.

It's too early for the ECB to call time on its inflation-busting mission. It was very late to the rate-hiking party, only shaking off eight years of negative rates last July. Even after this week's nailed-on increase, it will only have raised interest rates by 400 basis points, compared with the Fed's 500 basis points. However, if the Fed skips more than one meeting, it will dramatically reduce the pressure on the ECB to keep closing the gap.

The US central bank has successfully convinced the US Treasury market that it will skip just one meeting, and will be back raising rates next month. It wants to erase expectations for rate cuts this year which had crept increasingly into US money-market prices, and preserve flexibility. The ECB is paddling furiously in a similar boat, but it can ease back on the stroke rate if the Fed starts coasting. Perhaps it might want to join in the “skipping” game too by indicating it will only take rate decisions at quarterly economic reviews, which form part of this week’s agenda with the next one due in September.

The Australian and Canadian central banks had tried to preempt the Fed earlier this year by pausing. Unfortunately, they had to capitulate as still-too-sticky core inflation left them exposed. Both were forced into raising rates again by 25 basis points last week as the gap to Fed levels increased by too much for comfort.

It's clearly less than optimal that the euro zone slipped into recession over the winter, after two consecutive quarters of negative growth. So it wouldn’t be a huge surprise if growth expectations for this year are trimmed at this meeting’s economic update. A nudge upward in forecasts for core inflation, excluding food and energy, is also on the cards. Despite a dip to 5.3 percent in May's core measure from a peak of 5.7 percent in March, services prices and wage pressures remain elevated. This week's expected hike is needed to continue to subdue inflation; how much additional insurance policymakers will feel is required is now the bigger question.

Tinkering with economic expectations doesn't really change the trajectory the ECB is on — but the financial stability review it published on May 31 might. Vice-President Luis de Guindos, in the foreword to the report, emphasised the fragility of the euro banking system. That’s not necessarily stemming from the bloc’s banks, which have weathered failures in the US and Switzerland without much ado this year, but how sharply higher interest rates might be affecting the rest of the financial sector. As we have found out far too often in recent history, by the time something in the plumbing has broken, it’s often too late to react.

The ECB governing council ought to be increasingly conscious that due to monetary policy time lags, its year-long rate-hiking cycle has yet to be fully felt in the euro economy. Furthermore, not only has it paused its massive quantitative-easing bond purchases, but it has moved into passive tightening mode by no longer reinvesting around half of the maturing debt. If bond yields get stressed again, there is far less firepower to hand.

The ECB is too traumatised from letting runaway inflation slip away from it last year to suddenly pronounce an end to its current trajectory. But a Fed resolutely on hold would make it much easier for the ECB to sit the rest of the summer out at 3.5 percent. It won't want to make any commitments on that until its July 27 meeting — but it shouldn’t rule out the option to do so either. Conveniently, its next meeting is also the day following the Fed’s. Where the Fed leads, other central banks follow.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Views are personal and do not represent the stand of this publication.

Credit: Bloomberg