We expect 75bp at the meeting next week

In light of the numerous hawkish comments and sources stories during the weekend, we now change our ECB rate call.

We now expect ECB to hike 75bp next week, which will be followed by 50bp in October and 25bp in December, but acknowledge the increased uncertainty on the two latter hike size expectations. This is +25bp for our previous rate hike expectations at both the September and the October meetings, respectively, and we now see the endpoint of the ECB deposit rate at 1.5%.

As regards the reinvestment schedule, we currently do not foresee that ECB will change it, but increased market and ECB focus in coming months will intensify discussions ahead of December, where such decisions could be taken.

We believe the euro area will face a recession and ECB will hike into that, however, we also acknowledge that even without the ECB tightening, the European economy was in a severe situation to begin with a worsening energy crisis.

Intensifying inflation pressure - Hawks are on the wires

The European economy is facing a large supply shock on the back of spiralling gas and electricity prices in the past couple of weeks. As a result, we have seen a significant intensification of the near-term inflation pressure, with the inflation peak now projected by markets above 10% in December (compared to an expected inflation around 9% in September for most of Q2). As a result of the intensifying inflation dynamics we have also seen increased volatility and uncertainty around this. This has lead the particularly hawkish members of the ECB’s Governing Council to be very aggressive and argue for a sharp tightening need in the past couple of days. They also point to increased risks of inflation expectations becoming de-anchored or a wage/inflation spiral kicking in.

Important speech by Schnabel

During the Jackson Hole conference this weekend, the influential ECB member Schnabel outlined a very hawkish presentation, when she shared her view of the economy and inflation outlook. While Schnabel argued for a new era of volatility, with a less favourable environment where shocks are potentially larger, more frequent and persistent, she also recalled that the ECB has a price stability mandate, which may be controversial in an environment of elevated uncertainty and structural change in economic dynamics. However, she argues that in certain circumstances stabilising inflation is no longer equivalent to stabilising output during shocks and therefore implies a trade-off for monetary policy, between inflation and output. Furthermore, Schnabel said that central banks can take two paths: either 1) ‘caution’, in line with the view that monetary policy is the wrong medicine to deal with supply shocks or 2) ‘determination’ with a forceful response to inflation even at the risk of lower growth and higher unemployment. She points to three arguments of why central banks should act with determination now: 1) inflation uncertainty, 2) credibility and 3) the cost of acting too late. Further, she argued that in circumstances where the degree of inflation persistence is uncertain, it is ‘largely irrelevant whether inflation is driven by supply or demand. If a central bank underestimates the persistence of inflation – as most of us have done over the past one-and-a-half years – and if it is slow to adapt its policies as a result, the costs may be substantial.’

We were somewhat surprised with her speech and that she argued that the source of inflation was less relevant, as we question how tightening through higher rates will result in lower inflation, as the main source of inflation is coming from the food and energy component. However, the determination to price stability is very clear, as her remarks also reflect an acceptance that a recession with higher unemployment may be a result, but the risk of acting too late overshadows a more cautious approach.

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