European Central Bank In a Rock And a Hard Place

Written on 06/08/2022 by Lukman Otunuga, Senior Research Analyst at FXTM

Will ECB Hawks Deliver?

Does the ECB front-load a jumbo-sized rate hike at its meeting on Thursday? That is the key question facing markets as policymakers battle with surging prices and slowing economic activity. It is likely to be another battle between the hawks and the doves on the Governing Council with the new meeting-by-meeting approach fostering increased volatility in the euro, as it dabbles with the magical parity marker.

There’s no doubt the Nord Stream pipeline shutdown has come at the worst and most crippling time, for both businesses and households but also the ECB, as we head into winter. Inflation has already hit record highs and is set to potentially print in double-digits in the coming months.

That is why the ECB hawks have been growing ever louder in recent weeks, virtually demanding a 75-basis point rate hike at Thursday’s meeting. This kind of “forceful” monetary policy response, to prevent a wage-price spiral and inflation expectations de-anchoring, may come even at the risk of lower growth and higher unemployment.

But can aggressive rate hikes, and even a series of big moves, really bring down inflation in the eurozone? The economy is in zero danger of overheating and is actually expected to fall into a recession in the next few months, if it isn’t already in one, anyway. A smaller series of 50-basis point rate hikes is more preferable for the dovish side of the Governing Council who are keener to see the impact of these moves over an extended period of time.

Market expectations have leaned towards the recent hawkish rhetoric by pricing in nearly 175 basis points worth of tightening through until December this year. This equates to the equivalent of a 75-basis point move on Thursday and then two further half-point rate hikes in October and December.

Bottom Line

With central banks increasingly sensitive to inflation and proving their credibility in fighting price pressures, it seems the ECB must meet those market expectations to underpin support for the euro. Any disappointment will likely be quickly punished by the market with euro weakness.

The new staff projections will also be of interest as they will no doubt point to the ECB’s downside risk scenario of higher inflation and slower growth, or that rock and a hard place. It’s a tough spot for policymakers at the moment, partially brought on by their poor communication and tardiness in understanding the current nature of the inflation storm.

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