All ECB scenarios for the time and extent of interest rate hikes

By Leonidas Stergiou

Following the unusual for central bankers to post their interest rate intentions on a blog, the head of the European Central Bank, Christine Lagarde, effectively announced the end of the bond-buying program in early July and then a possible interest rate hike. the first on July 21 and the second on September 8.

However, there are voices from at least five of the 25 board members calling for an immediate rate hike of 50 basis points in July. Economists estimate that raising interest rates by 25 basis points is the most likely scenario, given the new forecasts for the Eurozone economy. At Thursday’s meeting, ECB economists will present the new quarterly forecasts until 2024, which are expected to revise downward growth and marginally upward inflation. Analysts’ forecasts published by international media and house reports converge on the same estimate.

The interest rate dispute

The difficulty with the timing and level of interest rate hikes is due to disagreements over how to handle a number of dilemmas, with all ECB members agreeing:

Firstthe ECB has been “trapped” in the decision to raise interest rates from markets, political pressures and the movements of other central banks, such as the Fed. Rising interest rates by the Fed and the Bank of England weaken the euro. This development may favor the largest European economy (Germany) and other export economies in Europe, but it bothers the average citizen (especially in Germany) due to inflation, while the pressure for wage increases is increasing.

In addition, the weakening of the euro exchange rate means an outflow of funds from the Eurozone to the dollar and other currencies with higher interest rates (hence falling markets in Europe, rising yields on bonds).

Secondly, already high inflation and rising money costs in the markets are already gnawing at growth. If we accept that a large part of inflation comes from the supply side (cost inflation), this part of inflation is slowing down growth and will continue to have a negative effect even after the ECB raises interest rates. Because raising interest rates can reduce the part of inflation that comes from demand. Therefore, inflation has already cost growth and will continue to cost until supply problems are resolved, regardless of rising interest rates. Instead, interest rates may reduce the demand side of inflation.

Thirdly, ECB and market economists can not yet determine how much of inflation is due to supply and how much to demand. The larger the share due to supply, the more inefficient the increase in interest rates will be in reducing inflation, while at the same time it will worsen growth. The analysis of inflation indicators does not offer a clear picture so far due to the change in consumer behavior during the lockdown and opening of markets and the shift of energy and transport costs to non-energy products and services.

Those who support small increases actually believe that the biggest problem of inflation is related to supply and less to liquidity during the pandemic and the spike in consumption with the opening of the market. Those calling for bigger and sharper increases believe that most of the inflation comes from excess liquidity and demand, which the faster they are contained, the shorter the duration of the negative impact of prices on growth.

Interventions in bond markets

The end of the bond market may be announced, but the ECB is keeping in mind the expansion of spreads, especially for the heavily indebted countries of southern Europe. It seems that he intends to deal with this in the first phase as follows:

Firstby continuing to reinvest in bonds and replace maturing securities (eg German) with young ones in Greece, under the PEPP program.

Secondly, reiterating that he will use all available tools to prevent speculation in spreads, without, however, giving more details. In this way he achieves two goals. In principle, it is not pressured to take immediate decisions, exacerbating the controversy between ECB members. Second, it creates uncertainty in the markets, as anyone who “bets” on expanding spreads can be trapped by ECB intervention.