Last Thursday, the European Central Bank raised key interest rates probably for the last time in this interest rate cycle. But the oil price poses a risk that the ECB has only taken a pause.
ECB raises key interest rates
The European Central Bank raised key interest rates by 0.25 percentage points on Thursday, September 14, 2023. The interest rate for the deposit facility is now 4%, and that for the main refinancing rate is 4.5%. Market participants were divided on whether a key interest rate hike would take place in September. Prior to the central bank meeting, market prices reflected a rate hike with a probability of around 65%. The reason given for the interest rate hike was that inflation, while declining, will remain too high for too long.
Falling inflation
The scope for key rate hikes has diminished significantly in the euro zone. Gross domestic product is growing at a very low rate and inflation is falling, albeit more slowly than hoped. The central bank’s growth estimate is now 0.7% for 2023 and 1.0% for 2024 and 1.5% for 2025. With regard to inflation, it is estimated to fall from 5.6% for 2023 to 3.2% for 2024 and 2.1% for 2025. Excluding the price components of food and energy – which is the traditional core rate – inflation is expected to fall to 2.9% for 2024 and 2.2% for 2025. The forecast thus still does not reach the inflation target.
Growth risks
In the coming week, the flash estimates of purchasing managers’ indices and consumer sentiment for the month of September, as well as the report on consumer price inflation in August, will provide new information on growth and inflation dynamics. To an increasing extent, economic activity indicators signal the risk of GDP contraction.
Monetary policy takes effect
In the design for monetary policy, the ECB applies three criteria:
- Inflation dynamics (disappointingly slow decline)
- Inflation forecasts (are above the 2% target)
- Impact of monetary policy.
From the ECB’s perspective, the rate hikes so far are having a strong impact because financing conditions have tightened and are dampening demand. The press release on the monetary policy decisions includes a key sentence: “Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.”
Restrictive level
At a level of around 4%, key interest rates have thus probably already reached a restrictive, i.e. growth-dampening, range. By comparison, estimates for the interest rate that does not have a dampening or supporting effect on growth range between 1.5% and 2.5%. This range is admittedly very wide, but the point is that the current level is above it. The important underlying assumption of the central bank here is that weak growth reduces inflation with an uncertain time lag.
However, the time-lagged effect of monetary tightening on economic growth and inflation is not satisfactorily well established in terms of both duration and magnitude. In other words, forecasts do not work well, which is why the central bank looks to published economic data. Indications that the key rate hike has already dampened growth are provided by both stagnating credit volumes and falling survey-based growth indicators (European Commission economic confidence, purchasing managers’ indices).
Rate hike cycle comes to an end
The key rate hike in the current weak growth environment was an opportunity to underline the commitment to achieving the inflation target. The ECB has now clearly signaled a conditional pause in the rate hike cycle. Of course, the central bank will maintain its inflation-fighting tone. Key rate cuts are therefore not to be thought of any time soon. If the economic data develop as projected, however, the key ECB interest rates will not be changed for some time. In the most likely scenario, the rate hike cycle will even come to an end.
Rising oil price
However, one should not rely too much on forecasts and certainly not on assumptions. Sometimes the models are wrong – a pandemic was not foreseen – or the assumptions for important parameters – such as a stable oil price – do not hold. In fact, the price of oil (Brent) has risen sharply in recent months. The most recent low was reached at $71 per barrel in early May. In the meantime, the oil price has risen to just under 94 U.S. dollars. Behind this is the OPEC+ policy of keeping oil production low. The immediate effects are easy to see: Higher production and transportation costs, lower purchasing power, higher energy prices and higher short-term inflation expectations. In the current environment of excessively high inflation, however, one key question stands out. Will we see pass-through effects like we saw in the 1970s and early 2020s (for the past two years)?
Conclusio
The central bankers hope that consumer prices excluding energy will not be persistently affected. However, if pass-through effects are indeed detectable, the ECB (after a pause) could see the conditions for further interest rate hikes met in a risk scenario.
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Legal note:
Prognoses are no reliable indicator for future performance.