27th July 2022

Rising interest rates: What is the short- and medium-term outlook?

The European Central Bank (ECB) has just announced its first rate hike since 2011. We asked William Telkes, Chief Economist and Vice President, Head of Private Banking at Spuerkeess, to comment on the ECB's strategy and to tell us how where he foresees rates positioning in 2023.

The ECB has just announced an increase in its key rates. What is the reason for this decision and does it come as a surprise?

On 9 June, during a press conference held in Amsterdam, European Central Bank (ECB) President Christine Lagarde mentioned a series of key rate hikes starting from her next monetary policy meeting on 21 July. This is a historic turning point for the common monetary policy, as it marks the first rate hike since 2011. Mrs Lagarde, during her speech, mentioned a rate hike of 0,25 points in July, followed by a very likely 0,5-point hike in September.

While the direction indicated by Mrs Lagarde in June was very precise, the ECB finally decided to take a more aggressive stance during its monetary policy meeting in July. Indeed, contrary to what had been announced, the ECB decided to raise its interest rates by 50 basis points, while indicating that other increases would remain highly likely. Also of note, it signalled the abandonment of its forward guidance policy, emphasising that any future decision would be taken based on changes in economic data.

Given that before the July decision, the deposit rate was at -50 basis points (pricing in market expectations), these various hikes should therefore bring the rate above 100 basis points by the end of the year. The approach adopted by the ECB therefore remains very gradual.

It should be noted that the tightening of monetary policy had already begun in early July with the ending of various monetary support measures, in the form of asset purchase programmes, in order to reduce the money supply in circulation.

In the end, this change of course is not a surprise, as the aim is to counter the skyrocketing inflation observed in the past several months. Over the past two months, inflation in the eurozone has exceeded 8%, i.e. more than four times the ECB's target, set at 2%.

How do you perceive inflation?

A few quarters ago, inflation was considered temporary. However, the post-Covid recovery, supply chain disruption and soaring commodity prices in the context of the Russian-Ukraine conflict continued to fuel inflation and extend it to the entire consumer basket. This is in addition to the weakness of the euro against the US dollar, which is pushing inflation higher given the rise in import prices.

This year, inflation will unfortunately remain very high and, although a drop is expected in 2023, inflation forecasts indicate that it will remain above the ECB's target. Against this backdrop of skyrocketing inflation, the ECB must therefore act to remain credible, especially since it is increasingly criticised for having waited too long to begin the gradual normalisation of its monetary policy.

What are the direct consequences of these ECB decisions?

In principle, the decisions taken by the ECB will ultimately have an impact on the demand of economic agents by reducing their growth prospects. Indeed, the rate hikes decided by the ECB should lead to an increase in borrowing, reducing the propensity to consume among consumers, as well as the propensity to invest among investors.

But since rates were at historically low levels and given the current inflationary environment, initial increases should have a limited impact on the economic sphere as the real rate, i.e. the difference between the interest rate deducted from inflation, will remain low at first. 

Is this the first in a series of increases?

The equation to be solved by the ECB is very complicated, as it is a real balancing act. The direction of monetary policy must be such that the ECB can ultimately achieve its objective of ensuring price stability, while avoiding pushing the European economy into recession.

As seen in the past, the normalisation of monetary policy will be gradual and on a regular basis. So yes, there will be a series of rate hikes in the coming quarters. Even though the impact on inflation will not be immediate, due to the rigidity of certain prices, the main objective of this series of increases is to break expectations of price increases by economic agents and thus strengthen the credibility of the ECB's actions.

As highlighted above, the deposit rate could thus exceed 100 basis points by the end of the year. These hikes are expected to continue in 2023 and, according to market rate expectations, bring the deposit rate above 150 basis points in the second half of 2023.