The ECB announced on Thursday 15 June its intention to raise its key interest rate further. The latter now stands at 4%, the highest recorded since 2008. Borrowing will be more and more expensive… In addition, this rate hike comes as the euro zone enters recession. At the same time, the FED (US central bank) aims to maintain a positive real rate. Consequently, the fight against inflation seems to be reaching its climax while the latter remains structurally high…
ECB continues to hike rates
While the euro zone has entered a slight recession, the fight against inflation remains a priority. Indeed, the European Central Bank (ECB) released its press release in which it announces its decision to raise the three main ECB interest rates by 25 basis points. Despite everything, this rise in rates is not a surprise. But the most interesting thing is to look behind the increase in inflation forecasts between now and the end of the year.
ECB projections in brief
Thus, according to the ECB’s latest macroeconomic forecasts, the latter expects headline inflation to average 5.4% in 2023, 3.0% in 2024 and 2.2% in 2025. Core inflation, ie inflation excluding commodities and energy, is expected at 5.1%. Which is significantly above the last projection at 4.6%. Lastly, growth has been revised down slightly but should remain positive. Which means that the recession of the first quarter of 2023 would not be sustainable. The ECB now forecasts that the economy will grow by 0.9% in 2023, 1.5% in 2024 and 1.6% in 2025.
Consequently, the ECB maintains its conviction of the effect of its policy on prices. She points out that borrowing costs have risen sharply and loan growth is slowing. Similarly, the tighter financing conditions are an important reason why inflation should continue to decline towards the target, as they should gradually dampen credit demand.
Finally, the Governing Council confirms that it will cease reinvestments under the asset purchase program from June. In other words, the ECB will fully pursue a policy of reducing its balance sheet. This fact is not insensitive to us, since mechanically, it reduces the liquidity of the financial markets.
How far will the ECB go?…
The Fed’s compass is to have a real rate of at least zero, as we will explain. That is to say that the key interest rate must be at least equal to (underlying) inflation. In this context, assuming that the ECB adopts a similar behavior with a maintenance of activity, we can anticipate a pivot. But the latter would not be for now…
In fact, underlying inflation in the euro zone should stand at 5.1% in 2023. This would reflect the increase in the key rate, in the logic of the FED, up to this level at least. There would therefore still be at least one percentage point of interest rate hikes before we see a real turnaround in monetary policy. However, this scenario necessarily depends on inflation projections and the economic situation. Finally, we must specify two elements.
On the one hand, the ECB was slow to raise its rates. Indeed, the ECB started to raise its rates from September / October 2022, compared to March 2022 for the FED. A rate hike until at least the end of 2023 for the ECB would therefore not be incongruous and difficult.
On the other hand, inflation in the euro zone is more persistent and more structural than in the United States. This would justify an increase in the key rate at least to the level of the Fed’s key rate. The latter is currently at more than 5%. Under these conditions, it is understandable that the ECB, usually more attentive to budgetary issues, is encouraged to pursue a more aggressive strategy.
The Fed also raises its inflation forecasts
The ECB is not the only one to remain aggressive. In fact, the US central bank is leading the dance. Moreover, the United States is benefiting from a more favorable economic situation than the euro zone for such a restrictive policy. Indeed, inflation fell back to 4% in May (against 4.9% in April), a 2-year low for the United States. But it is nevertheless relevant to note that underlying inflation (core) stands at 5.3%. This is combined with a growth enhancement.
During his last meetingthe Fed raised its inflation and growth targets. Inflation is forecast at +3.2% at the end of 2023, as well as +3.9% for underlying inflation. At the same time, growth is expected for the end of 2023 at 1%, followed by 1.1% in 2024. We must therefore recall that the American economy has entered into virtual “recession” early 2022. GDP had contracted, like the GDP of the euro zone today, before resuming its growth. It seems clear, in this context, that the rise in rates in the absence of a slowdown in employment or activity is appropriate.
Towards positive real rates
It is an implicit desire that can be read through Jérôme Powell: to maintain positive real rates. The underlying inflation rate is 5.3% for the United States, when the key rate is above 5%. We are therefore in the presence of real rates that are almost zero or slightly positive. The Fed’s pause on its rate hikes therefore comes at exactly the time when the key rate is hitting hard inflation, or core inflation. Further (potential) rate hikes would therefore be preventive in nature. Rumors circulate that a real rate of 1% to 2% would be sufficient to effectively reduce the demand for credit, and ultimately inflation. In this case, a Fed policy rate of 5.5% would be consistent with core inflation projected at 3.9% at the end of 2023.
We have already discussed in a previous article the importance of equality between the real rate and the real growth. In addition, maintaining a positive real rate also means that capital is more remunerated. For the borrower, the credit is then a source of an effective cost, when the lender benefits from an enrichment effect. This encourages contraction of credit demand, and ultimately in theory, to reducing inflation.
Clearly, this is great news for concerned savers. By contrast, a negative real rate encourages companies and governments to borrow again and again. Indeed, tax revenue or turnover grows faster due to inflation than the cost of interest. Consequently, the effect of the increase in the key interest rate is painless on inflation as long as the latter does not approach inflation.
A mixed market reaction
A positive real rate is detrimental to long-term equity market performance. Nevertheless, the Fed’s decision does not seem to have particularly disturbed the markets. The latter remain in a form of wait-and-see before the next (or constant) rate hikes.
After having marked a decline, the price of gold finally turned sharply positive. On the other hand, the price of bitcoin (BTC) ended down. For their part, the S&P 500 and the euro rebounded strongly. The Dow also hit a new yearly high. The markets have therefore welcomed the pause on interest rates rather positively, even if the reaction in Europe is much more mixed. As a result, this means that the markets have been very wait-and-see in the face of a pause in rate hikes.
In conclusion
In the end, it seems clear that the central banks will conduct a sufficiently aggressive policy. The implicit objective is certainly to encourage fiscal and monetary discipline. This requires a return to a positive real rate, taking into account underlying inflation. Indeed, core inflation, ie excluding commodities and energy, is becoming predominant. That is, inflation is self-sustaining. This is precisely the goal of struggle that central banks share.
Moreover, the increase in growth and inflation targets in the United States and in the euro zone is not helping matters. The monetary authorities could thus be encouraged to carry out preventive and more virulent rate hikes. The purpose would thus be to effectively reduce the demand for credit from businesses and governments (which is not weakening), in order to then reduce inflation.
The new ECB rate hike is therefore not surprising. And these increases could still continue. Nevertheless, these rate increases on both sides of the Atlantic come with a job market in good shape. While economic activity in the United States is accelerating, the euro zone is entering a recession. But this recession is not considered to be long-lasting by the ECB and we could therefore see continued growth. Finally, the reaction of the financial markets is rather positive.
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