The European Central Bank (ECB) is indeed facing a challenging decision regarding interest rates at its upcoming policy meeting. Market expectations have been quite volatile in recent weeks, reflecting the uncertainty surrounding the decision.
At the beginning of September, the market was largely discounting the possibility of a 25 basis point (bp) rate hike by the ECB at its September meeting, with odds as low as 20%. This sentiment was influenced by weaker-than-expected economic data that signaled a slowdown in the Eurozone economy.
However, the outlook has shifted rapidly, and the odds of a 25 bp rate hike have increased to over 50%. This change in sentiment is primarily driven by mounting evidence of persistent inflation in the Eurozone. A Reuters report indicating that the ECB’s new economic estimates, set to be released on Thursday, will project Eurozone inflation for 2024 above 3% has played a significant role in this shift.
Despite the ECB’s 2% inflation target, Eurozone core Consumer Price Index (CPI) remains well above this level, currently standing at +5.3% year-on-year (y/y). Some ECB policymakers have suggested that the central bank may need to tighten monetary policy further to combat inflation.
ECB Governing Council member Knot’s warning that investors might be underestimating the likelihood of rate hikes is indicative of this stance. Even though there are concerns about economic weakness, such as the recent -1.1% month-on-month (m/m) decline in Eurozone industrial production, inflation pressures are driving the debate.
However, some analysts believe that signs of economic weakness will compel the ECB to pause its rate hike cycle. For instance, Toronto-Dominion Bank expects the ECB to keep rates steady after Thursday’s meeting. The Bloomberg report projecting a -0.3% contraction in German GDP for 2023, coupled with weak economic indicators, underscores concerns about economic recovery.
In this situation, the ECB finds itself in a challenging position. Persistent inflation suggests a need for further tightening, but economic weakness may necessitate a pause. ECB Executive Board member Schnabel’s comments about the economic slowdown potentially reflecting long-term structural shifts rather than just cyclical forces indicate a willingness to consider rate hikes despite a slowdown.
Ultimately, the ECB’s decision will depend on its assessment of the balance between inflationary pressures and economic growth. The central bank faces a “lose-lose” situation, as both raising rates and keeping them unchanged carry risks and consequences. The decision will be closely watched by financial markets and policymakers, and its outcome will have significant implications for the Eurozone’s economic trajectory.
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