ECB Braves One Final Hike As Forecasts Show Rising Stagflation Risk

The ECB on Thursday raised rates for a 10th time, in what was likely the final hike of the most aggressive tightening campaign in the institution’s relatively short history.

Headed in, the decision was billed as a cliffhanger and a toss up. Ultimately, hawks won the day.

The statement repeated that inflation is “still expected to remain too high for too long,” even as it “continues to decline.”

The problem (well, there are a lot of problems, but the main problem) is that core and services inflation aren’t actually declining. Core is meandering near record highs. That means the inflation impulse is “coming from inside the house,” to employ a tired American horror movie plot cliché.

The irony at this month’s policy gathering was that the specter of recession probably made a final hike more likely. With the European economy displaying signs of weakness and Germany mired in a seemingly interminable malaise, there might not be another opportunity to raise rates.

It’s probably an exaggeration to suggest things could be so bad on the growth front a month from now that September’s meeting was a “now or never”  moment, but that’s a stylized way to think about it.

The new staff projections see inflation averaging 5.6% this year, 3.2% in 2024 and 2.1% in 2025. The figures for this year and next were revised higher “mainly reflect[ing] a higher path for energy prices.” “Underlying price pressures remain high, even though most indicators have started to ease,” the ECB remarked.

The growth outlook for next year was downgraded meaningfully from 1.5% in June’s forecasts to just 1%. “With the increasing impact of this tightening on domestic demand and the weakening international trade environment, ECB staff have lowered their economic growth projections significantly,” the statement said.

Obviously, upward revisions to the inflation path combined with downward revisions to the growth outlook make for a suboptimal conjuncture. The takeaway is that ECB staff has effectively marked up the odds of stagflation.

The forward guidance plainly suggested rate hikes are over. Or at least that the ECB would like for rate hikes to be over, data permitting. “Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target,” the statement read. “The Governing Council’s future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary.”

QT is continuing apace via the APP portfolio (i.e., the assets accumulated under “regular” QE). Guidance around the PEPP portfolio (the assets purchased under the pandemic QE program) was unchanged: Principal payments from maturing assets will be reinvested “at least” through the end of next year.

As a reminder, PEPP reinvestments are a kind of extra insurance policy against spread-widening in the periphery. That is, the ECB can direct the reinvestments to tamp down fragmentation risk as manifested in unduly wide spreads versus core bonds.

So, the message from the September ECB meeting was: We’re done, hopefully, but expect rates to stay higher for longer.


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