The European Central Bank is expected to raise its key interest rate to its highest level in 22 years while warning that underlying inflationary pressures are proving to be more persistent than they had hoped.
The outcome of the ECB Governing Council’s meeting on Thursday is expected to underline that a majority of interest rate setters still believe that the risks of a rate hike that is too small outweigh the downsides of potentially overly tight monetary policy.
However, after the US Federal Reserve paused its streak of 10 consecutive rate hikes on Wednesday, the ECB is likely to signal that it is nearing the end of its unprecedented rise in eurozone borrowing costs.
Eurozone interest rates remain lower than in the US and ECB rate setters are broadly in agreement that the key policy rate should be raised for the eighth time on Thursday, which would raise the deposit rate by a quarter of a percentage point to 3. 5 percent, the highest since July 2001.
Isabel Schnabel, Member of the Executive Board of the ECB said this month: “Given the high uncertainty about inflation persistence, the cost of doing too little continues to outweigh the cost of doing too much.”
Headline inflation in the eurozone fell from its peak of 10.6 percent in October to 6.1 percent in May. But this was mainly due to lower energy prices and it remains well above the ECB’s 2 percent target.
The central bank has indicated that it will not stop raising interest rates until underlying inflation, excluding more volatile elements such as energy and food, has clearly fallen.
While some measures of underlying inflation in the eurozone fell for the first time in May, this mainly reflected the introduction of Germany’s subsidized public transport ticket of €49 per month.
ECB President Christine Lagarde said earlier this month there was still “no clear evidence that underlying inflation has peaked” and warned that “rising wage pressures are becoming an increasingly important driver of inflation”.
Wages per employee in the eurozone rose 5.2 percent in the first quarter from a year ago, up from 4.8 percent in the fourth quarter, according to ECB data released last week.
When the ECB releases new quarterly growth and inflation forecasts on Thursday, they are expected to reflect higher wage growth and tighter services prices. Barclays economist Silvia Ardagna predicted that the ECB would raise its forecast for core inflation, excluding energy and food prices, from 4.6 percent to 5 percent for this year.
Tourism bookings and spending in Mediterranean countries like Spain are on track to rise above pre-pandemic levels this summer. This is expected to lead to a further increase in airfares, hotels and package holidays, which have already increased by double digits over the past year.
Mark Wall, chief economist at Deutsche Bank, predicted that a strong tourism season could be enough to reverse the recent decline in underlying price pressures — raising the prospect of further quarter-point interest rate hikes not only at the rate setters’ meeting in July, but also in September.
However, other ECB observers think only one more rate hike is likely after this week as the debate over the trade-off between inflation and growth becomes more balanced.
Pigeons have urged more caution after revised official data showed the euro-zone economy contracted over the past two quarters. “Our monetary tightening will be felt in the coming months,” said ECB Executive Board member Fabio Panetta, adding that it “could translate into prolonged sluggishness in economic activity, or even a technical recession.”
Retail sales in the Eurozone were down 2.6 percent year-on-year in April, after adjusting for inflation. Industrial production in the bloc has barely grown in the past year and is said to have fallen in April without a surge in Irish production due to intellectual property shifts by multinationals.
The gloomier outlook for growth is expected to be reflected in a cut in the ECB’s forecast for 2023 from the 1 percent growth it predicted in March.
“The economy has entered a mild recession, inflation is falling, global headwinds have plagued production and credit volumes have begun to contract,” said Holger Schmieding, chief economist at German bank Berenberg. “The recent flood of news has strengthened the pigeons’ case against tightening much further.”
But after being widely criticized for being too late to react to last year’s rise in inflation, the ECB seems determined to keep raising rates until there is little doubt that price growth is firmly on track towards its target of 2 percent.
“Having misjudged inflation on one occasion, the Governing Council has no intention of gambling that rate hikes so far will be enough,” said Stefan Gerlach, former deputy head of the Bank of Ireland.