The ECB hiked interest rates as expected today to 2.5%, they also revised up their inflation expectations. This was also expected, however, the euro is extending mild losses on the back of this report, European bond yields are higher, however, it is hard to see if this is a reaction to the ECB or to the move higher in the oil price to more than $102 per barrel.
Lagarde’s ‘Kevin Warsh’ moment
Christine Lagarde would not be drawn on future rate hikes, and took a ‘Kevin Warsh’ stance with the media today. She was firm that she was not precommitting to a path for interest rates. She has kept her options open because Eurozone inflation is driven by a supply shock. This weighed on the euro, which is moving back towards $1.16, as the market assumes that the ECB may not be as hawkish as some expect, even if future rate hikes are likely.
Inflation forecasts revised higher
The ECB raised its inflation outlook for the next two years, and sees inflation at 2.1%, just above target, in 2028. This suggests that ECB economists currently see the energy price shock having a long term effect on the economies of the single market. We need to wait and see how the ECB reacts to the overshoot in inflation as far out as 2028. A small overshoot like 0.1% could be ignored, especially since it is linked to exceptional circumstances that are caused by external factors.
Interest rate expectations have recalibrated on the back of this decision. Two further interest rate hikes are now expected, but the market now expects these two hikes by March and not April, which can be seen as a mild hawkish reaction to the ECB staff forecasts.
ECB also sympathetic to growth outlook
It is worth noting that the ECB added a qualifying risk assessment: ‘The outlook remains highly uncertain, with risks to the upside for inflation, and to the downside for economic growth’. While the ECB keeps the door open for further interest rate hikes, and it remains committed to its inflation target, the ECB also notes that the situation with the war in the Middle East is highly uncertain. This uncertainty was reiterated by Christine Lagarde, who also said that trade tensions along with supply constraints are major threats to the growth outlook this year.
Right now, neither Iran or the US are willing to cede ground and bring the latest escalation in the conflict to a close. This is why the oil price is surging above $102 per barrel. However, a fresh ceasefire and/ or new peace talks could have an ameliorating effect on the oil price that changes the inflation picture for the ECB and other central banks around the world.
FX outlook
EUR/USD is weakening on the back of this meeting, even though the reaction has been mild so far. It initially fell below $1.16, as the ECB’s ‘hawkish’ inflation forecast upgrade was neutralised by concerns about the economic outlook included in the statement. However, for now, EUR/USD is still stuck in its recent tight range between $1.1580 – $1.1650.
No forward guidance from Lagarde
If Christine Lagarde sits on the fence at today’s press conference, then the euro could remain range bound, but if she settles on the hawkish or the dovish side, then expect the euro to move beyond this tight band.
Overall, the ECB is stuck in the same dilemma as its peers. Hiking rates to combat headline inflation risks will threaten the stability of economic growth. For now, the ECB has left the door open to further hikes, but Lagarde has done this without rocking the boat, or the bond market. While we expect another hike in December, it is unclear what happens after that.
