ECB grapples with knife-edge decision on interest rates

The European Central Bank’s hawks have their last big chance for many months to raise interest rates this week, according to analysts who are divided on whether they will be able to seize it.

There are potential pitfalls for the ECB in whichever decision it makes: keeping rates on hold invites criticism that it is giving up too early in the fight against inflation, but raising them risks making a looming economic downturn worse.

Ahead of Thursday’s knife-edge decision, Dutch central bank boss Klaas Knot said investors may be underestimating the possibility of a rate rise, not least because persistently high wage growth remains “pretty far off” the level consistent with inflation falling to the ECB’s 2 per cent target.

Others, such as Germany’s central bank head Joachim Nagel and Belgian governor Pierre Wunsch, have echoed those concerns.

“If they don’t hike in September, the window will close,” said Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management. “GDP growth is on the verge of contracting, and credit growth is slowing fast.”

Whatever happens, this week’s decision is seen as the hardest to call since before the ECB started to raise borrowing costs in July 2022, made more tricky by the lack of any signals from the central bank on its next move for the first time in over a year.

The ECB, led by president Christine Lagarde, has raised borrowing costs at nine consecutive policy meetings, lifting its benchmark deposit rate from an all-time low of minus 0.5 per cent to a record high of 3.75 per cent in a push to tame the biggest inflation surge for a generation.

More “dovish” members such as Portugal’s central bank boss Mário Centeno say the risk of “doing too much” has become “material” as the outlook for the eurozone economy has deteriorated in recent weeks. 

Ignazio Visco, governor of Italy’s central bank, said: “I believe we are near the level where we can stop raising rates,” citing measures of underlying inflationary pressure that show it is declining.

ECB president Christine Lagarde
ECB president Christine Lagarde has over seen nine consecutive rate rises © Boris Roessler/dpa

Investors are betting on a pause, with derivatives markets pricing just a 35 per cent chance of the ECB raising its deposit rate to 4 per cent on September 14. The chance of higher rates fell last week after data revealed sliding business activity, falling German industrial production and a downward revision to second-quarter eurozone growth from 0.3 per cent to 0.1 per cent. 

Inflation in the eurozone has halved since last year to 5.3 per cent in August. But it is still running well above the ECB target, while upward pressure is coming from rising oil prices and a weakening euro that pushes up import costs, meaning another rate rise is still on the cards.

“I anticipate that they [the hawks] will prevail next week and hike,” said Vítor Constâncio, former vice-president of the ECB, predicting inflation will remain high even as the eurozone stagnates. “Stagflation is coming to the euro area, which should imply that for quite some time there will not be other hikes.”

The ECB will also publish new quarterly forecasts on Thursday, which are likely to show lower estimates for growth this year as well as slightly higher inflation expectations for both 2023 and 2024.

Last year, the ECB was criticised for being too slow to start raising rates after Russia’s full-scale invasion of Ukraine sent energy and food prices soaring. The US Federal Reserve reacted quicker and inflation is now lower in the US than in the eurozone. 

“It looks bad if they pause when inflation is still at 5.3 per cent,” said Ludovic Subran, chief economist at German insurer Allianz. “Is the ECB throwing in the towel too early? It is spooky for people who worry about this narrative of stagflation in Europe.”

Another reason for the ECB to keep raising rates is a concern that rapid wage growth will keep price pressures stubbornly high, particularly for services companies, for which labour makes up the majority of their costs.

Figures published by the ECB last week showed pay per employee in the eurozone rose at an annual rate of 5.5 per cent in the second quarter, while unit labour costs were up 6.4 per cent — both near all-time highs. 

Line chart of eurozone unit labour cost index (annual per cent change) showing Labour costs are rising at rapid rates in the eurozone

“The hawks will be able to rely on the numbers to support their position,” said Claus Vistesen, chief eurozone economist at researchers Pantheon Macroeconomics, adding that falling productivity risked fuelling inflation.

However, the economic outlook is increasingly grim, bank lending has slowed sharply, the eurozone’s labour market is starting to weaken. That all supports the doves’ cause.

Core inflation — which excludes energy and food and is seen as a better indicator of underlying price pressures — looks to have peaked this summer. It is expected to fall further as economic activity slows and once discounted German public transport tickets from last summer fall out of the year-on-year comparison this month. 

“What is the point of tightening monetary policy?” said Dirk Schumacher, a former ECB staffer now working as an economist at French bank Natixis. “It is to slow the economy. Well that is happening now.”

Some predict that, as the ECB nears the peak on rates, it could look to tighten policy using other tools, such as shrinking its balance sheet quicker through so-called quantitative tightening (QT) by bringing forward the end of reinvestments in the €1.7tn bond portfolio it started buying in the pandemic.

“We expect the ECB to accelerate the process of QT,” said Camille de Courcel, head of European rates strategy at French bank BNP Paribas.

Another option could be to cut the amount of interest paid to commercial banks or governments on their deposits at the ECB.

Whether the ECB raises rates or not, the biggest challenge for Lagarde could be trying to convince markets that borrowing costs could still rise should inflation end up remaining too high.

Krishna Guha, a former Fed official now vice-chair at US investment bank Evercore-ISI, said: “The ECB is probably done in September either way.”