The European Central Bank is expected to raise its main interest rate to its highest level for 22 years, while warning that underlying inflationary pressures are proving stickier than it hoped.
The outcome of Thursday’s ECB governing council meeting is set to underline how a majority of its rate-setters still think the risks of raising rates too little are greater than the downsides of potentially over-tightening monetary policy.
However, after the US Federal Reserve hit pause on its series of 10 consecutive rate rises on Wednesday, the ECB is likely to indicate it is approaching the end point in its unprecedented increase in eurozone borrowing costs.
Eurozone rates remain lower than in the US and ECB rate-setters broadly agree on the need to raise its main policy rates for an eighth time on Thursday, which would lift its deposit rate by a quarter percentage point to 3.5 per cent, its highest since July 2001.
ECB executive board member Isabel Schnabel said this month: “Given the high uncertainty about the persistence of inflation, the costs of doing too little continue to be greater than the costs of doing too much.”
Headline inflation in the eurozone has fallen from its 10.6 per cent peak in October to 6.1 per cent in May. But this was mainly due to lower energy prices and it remains well above the ECB’s 2 per cent target.
The central bank has signalled it will not stop raising rates until underlying inflation, excluding more volatile elements like energy and food, is clearly falling.
While some measures of underlying eurozone inflation dipped for the first time in May, this mainly reflected the introduction of Germany’s subsidised €49 monthly public transport ticket.
ECB president Christine Lagarde said earlier this month there was still “no clear evidence that underlying inflation has peaked” and warned that “mounting wage pressures are becoming a more important driver of inflation”.
Pay per eurozone employee rose 5.2 per cent in the first quarter compared with a year ago, up from 4.8 per cent in the fourth quarter, according to ECB data published last week.
When the ECB issues new quarterly projections for growth and inflation on Thursday, these are expected to reflect higher wage growth and stickier services prices. Barclays economist Silvia Ardagna predicted the ECB would raise its forecast for core inflation, excluding energy and food prices, from 4.6 per cent to 5 per cent for this year.
Tourist bookings and spending in Mediterranean countries like Spain are on track to bounce back above pre-pandemic levels this summer. This is set to lead to a further surge in air fares, hotels and package holidays, which have already risen at double-digit rates over the past year.
Mark Wall, chief economist at Deutsche Bank, forecast a strong tourism season could be enough to reverse the recent dip in underlying price pressures — raising the prospect of further quarter-point rate rises not only at rate-setters’ July meeting, but also in September.
However, other ECB watchers believe only one more rate rise is likely after this week as the debate on the trade-offs between inflation and growth becomes more balanced.
Doves have urged more caution after revised official figures showed the eurozone economy shrank in the past two quarters. “Our monetary tightening will be felt in the coming months,” said ECB board member Fabio Panetta, adding this could “translate into prolonged sluggishness in economic activity, or even a technical recession”.
Eurozone retail sales were down 2.6 per cent year-on-year in April, after adjusting for inflation. Industrial production in the bloc has barely grown over the past year and would have fallen in April without a sharp jump in Irish output due to intellectual property shifts by multinationals.
The gloomier prognosis for growth is expected to be reflected in a cut to the ECB’s forecast for 2023 down from the 1 per cent expansion it forecast in March.
“The economy has fallen into a mild recession, inflation is on the way down, global headwinds are battering manufacturing and credit volumes are starting to contract,” said Holger Schmieding, chief economist at German bank Berenberg. “The recent news flow has strengthened the case of the doves against tightening much further.”
But after being widely criticised for being too late to respond to last year’s surge in inflation, the ECB seems determined to keep raising rates until there is little doubt that price growth is firmly heading towards its 2 per cent target.
“Having misjudged inflation once, the governing council is not about to gamble that the interest rate increases so far will be enough,” said Stefan Gerlach, the former deputy head of Ireland’s central bank.
