The European Central Bank (ECB) has announced a 25 basis point increase in interest rates as expected, reaching its highest level since 2001. Christine Lagarde, ECB President, indicated in a press conference that another rate hike could be forthcoming in July, despite ongoing economic slowdowns.
On June 15, the ECB raised all three of its key interest rates by 25 basis points. The deposit facility rate is now at a 22-year high of 3.50%, with the main refinancing rate and the marginal lending rate standing at 4.00% and 4.25%, respectively. In less than a year, these key ECB interest rates have collectively seen an increase of 400 basis points.
Despite a lower-than-expected Harmonized Index of Consumer Prices (HICP) in Europe in May, up 6.1% year-over-year-the lowest since the Russo-Ukrainian conflict-core inflation remains stubborn. Food, alcohol, and tobacco inflation rates have fallen by 10 percentage points month-over-month, but still show a significant year-over-year increase of 12.5%.
The ECB noted that although inflation rates have been dropping, they are expected to remain high for a long time, and the rate-hiking cycle is not over yet. The council decided to aim to return inflation rates to a medium-term target of 2%.
Lagarde, in the press conference, reiterated that overall inflation is falling, but underlying price pressures remain strong, and the labor market is a key driver of inflation. She added that the ECB has not yet reached its goal and further interest rate hikes are likely in July.
Wage growth is increasingly becoming a significant source of inflation. Economic growth and inflation prospects remain highly uncertain. Energy prices, food prices, and wage agreements are all expected to pose upward risks to future inflation.
In its statement on the interest rate hike, the ECB pointed out that the hikes are being transmitted to the financial environment and are gradually impacting the overall economy. Rising borrowing costs and slowing loan growth are key factors in further reducing inflation towards the target. The expected interest rate hikes will further suppress demand.
Many ECB officials believe that the interest rates will peak after another 25 basis point hike in July. However, some suggest that the hikes may need to continue until September to sustainably bring inflation back to a target level of 2%.
In response to this, Lagarde said that the ECB has not considered pausing the rate hikes, stating that there is still room to raise rates and emphasizing the importance of data in decision-making.
The ECB has revised up its CPI growth expectations and revised down its GDP growth expectations. The CPI is expected to grow 5.4% in 2023 (previously 5.3%), 3.0% in 2024 (previously 2.9%), and 2.2% in 2025 (previously 2.1%). Meanwhile, GDP is expected to grow 0.9% in 2023 (previously 1%), 1.5% in 2024 (previously 1.6%), and 1.6% in 2025 (unchanged).
Furthermore, the ECB will stop reinvesting in assets under its asset purchase program (APP) starting in July.
Traders increased the likelihood of the ECB's deposit facility rate peaking at 4% to 50%, the highest level since March. The euro rose briefly against the U.S. dollar to 1.8043. The euro also rose 1.1% against the yen to 153.39, the highest level since 2008.
European stock markets collectively fell, with the German DAX index down 0.76%, the UK FTSE 100 index turning negative, the French CAC 40 index down 0.98%, and the Euro Stoxx 50 index down 0.82%.
Spot gold regained ground to $1942.68 per ounce. The yield on two-year German bonds rose to its highest level since March.
As the ECB embarks on a new round of rate hikes, the U.S. Federal Reserve has just hit the pause button on its own rate hikes. As a result of a series of rate hikes, the European economy has technically entered a recession, which increases the possibility of the end of the rate-hiking cycle.
Lagarde stated during the press conference that economic growth had stagnated in recent months, short-term growth might remain weak, but it might regain momentum later this year.
The services sector remains resilient, and the labor market continues to be a robust supporter of economic growth.
The Eurozone's GDP contracted by 0.1% quarter-over-quarter in the first quarter of this year, 0.2% lower than the preliminary estimate. Meanwhile, the GDP for the last quarter of the previous year also fell by 0.1% quarter-over-quarter. Two consecutive quarters of GDP contraction signify a technical recession for the Eurozone economy.
One of the main causes of the recession is Germany, considered the "engine of the European economy," which has also experienced two consecutive quarters of GDP contraction, entering a technical recession.
Analysts pointed out that May's data provided hope that policies are finally starting to take effect, especially in the consumer sector and the housing market. With an economic recession already present, the risk of overuse of monetary policy is steadily increasing, and the debate about how to handle policy at the next meeting in July will likely be more intense than usual.
Holger Schmieding, an economist at Berenberg, predicted a "heated summer debate" between hawks and doves, but suggested a "final hike" of 25 basis points at the next meeting in July is possible. Fritzi Koehler-Geib, Chief Economist at KfW, said the ECB "will proceed cautiously, with another hike in July."
