The key question facing markets ahead of tomorrow’s ECB’s rate decision is whether policymakers front-load a jumbo-sized rate hike? The bank is wrestling with surging prices and slowing economic activity as the eurozone is engulfed in an energy crisis. The battle between the hawks and the doves on the Governing Council will be critical, and the new meeting-by-meeting approach will foster increased volatility, as the single currency sinks below the magical parity marker.
There’s no doubt the Nord Stream pipeline shutdown has come at the worst time, for both businesses and households but also the ECB, as we head into winter. Inflation has already hit record highs and is set to potentially print in double-digits in the coming months. That is why the ECB hawks have been growing ever louder in recent weeks demanding a 75-basis point rate hike at Thursday’s meeting. This kind of “forceful” monetary policy response, to prevent a wage-price spiral and inflation expectations de-anchoring, will come even at the risk of lower growth and higher unemployment.
Indeed, the economy is expected to fall into a recession in the next few months if it isn’t already in one. A smaller series of 50-basis point rate hikes is more preferable for the dovish side of the Governing Council who are keener to see the impact of these moves over an extended period of time.
Market expectations have leaned towards the recent hawkish rhetoric by pricing in nearly 165 basis points worth of tightening through until December this year. This equates to the near-equivalent of a 75-basis point move on Thursday and then two further half-point rate hikes in October and December.
With central banks increasingly sensitive to inflation and proving their credibility in fighting price pressures, it seems the ECB must meet those market expectations to underpin support for the euro. Any disappointment will likely be quickly punished by the market with euro selling. We note the EU summit on the energy crisis taking place on Friday which may affect volatility as well. Any region-wide cap on energy bills could put a lid on inflation expectations and possibly give a lifeline to the current grim economic outlook.