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ECB to hike costs further even as markets grasp at straws

The European Central Bank (ECB) is highly likely to implement the highest borrowing costs in 22 years on Thursday, demonstrating its commitment to combating high inflation despite the weakening euro zone economy.

The region’s economic growth is currently stagnating, and inflation has been moderating due to declining energy prices and the significant increase in interest rates, marking the largest hike in the ECB’s history.

In contrast, the U.S. Federal Reserve recently halted its streak of ten consecutive rate hikes, signaling to global investors that the tightening cycle in developed economies may be approaching its end, even though further rate increases in the U.S. remain a possibility.

However, inflation in the euro zone remains unacceptably high for the ECB, standing at 6.1%—more than three times the bank’s 2% target. Underlying price growth, which excludes food and energy, is only just beginning to slow down.

Consequently, the ECB is likely to continue on its path of tightening monetary policy, especially since it failed to anticipate the current period of high inflation and started raising rates later than many of its global counterparts last year.

Carsten Brzeski, the global head of macro at Dutch bank ING, emphasized the ECB’s need to avoid any missteps, stating that they “simply cannot afford to mess it up once again.”

The ECB is expected to raise the deposit rate, which is the interest rate banks pay to securely park cash at the central bank, for the eighth consecutive time, by 25 basis points to 3.5%—the highest level since 2001.

Economists surveyed anticipate a similar increase in July, an action that several policymakers have already indicated, possibly to exert pressure on their colleagues ahead of Thursday’s meeting.

While the direction of rate hikes beyond July is less certain, ECB President Christine Lagarde is anticipated to keep the possibility of a further increase in September on the table and push back against investor expectations of rate cuts early next year.

JPMorgan economist Greg Fuzesi highlighted the importance of the forward guidance provided by the ECB, expressing skepticism that the statement would signal or suggest that the July hike might be the last.

Although the Fed’s decision to pause was expected to temper expectations of ECB rate hikes, investors actually raised their rate expectations overnight, projecting that the deposit rate could reach 3.85%.

This suggests that another rate hike after July is becoming increasingly likely.

The ECB will release its updated economic forecasts, which are expected to indicate inflation approaching, yet still above, 2% next year before reaching the target in 2025.

While this might typically imply a pause in policy tightening, the ECB has been cautious about relying solely on its projections after several years of missed targets.

Instead, euro zone rate-setters have been focusing on actual economic data, which have presented a mixed picture.

The euro zone experienced two quarters of contraction due to Germany’s economic decline, resulting in a mild recession last winter. The region is expected to achieve only modest growth this year.

However, unemployment is at record lows, and wage growth is increasing, albeit still lagging behind inflation.

Although headline inflation has been rapidly declining since reaching double digits late last year, underlying prices, particularly for services, have yet to exhibit the decisive drop that ECB policymakers have stated they would need to observe before easing monetary policy.

The higher borrowing costs have led to reduced demand for credit from households, companies, and banks’ willingness to lend. Nevertheless, consumption has remained robust in nominal terms.

These divergent factors are likely to provide arguments for both the hawkish majority within the ECB’s Governing Council, advocating for further rate hikes, and the dovish minority, advocating for a pause.

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