MFS: The ECB on a mission to control inflation with steady hikes in Q1

MFS: The ECB on a mission to control inflation with steady hikes in Q1

Monetary policy ECB
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By Annalisa Piazza, Fixed-Income Research Analyst, MFS Investment Management

We expect the ECB to hike interest rates by 50bp to 2.5% at its Governing Council meeting this Thursday. The pace of hiking is not expected to slow down anytime soon and another 50bp hike is also likely to be delivered in March as the ECB is clearly on a mission to bring inflation down from the current elevated levels.

Markets are pricing in nearly 150bp of cumulative policy rates hikes by the early summer and a pause until year end. We suspect the ECB will reiterate its hawkish message in February as there are still uncertainties regarding underlying inflationary pressures and a change of tone would undermine the ECB’s credibility and inflation would completely lose its anchor.

Risks around future inflation remain high, and we can probably see the peak for headline inflation being behind us, but core inflation might still have some room to grow, with pass-through effects of higher energy prices filtering through the price formation chain. Despite falling risks of recession due to the combination of the slight improvement in purchasing power, reduced supply constraints and picking up demand from China, the impact of tighter monetary policy need to filter through the economy via slower investments and possibly a contraction in housing activity. In a nutshell, the overall picture remains blurred but the hawks at the ECB Governing Council will continue to emphasise the need to keep rates in restrictive territory to avoid inflationary expectations to get out of control.

Notably, the ECB is – like other Central Banks in the DM space – hiking at a stage where GDP growth is still running below potential (despite the less dire energy situation) and more tightening will be delivered until inflation rolls over and there are signs that underlying inflationary pressures are stabilising. In such a scenario, we still see risks of higher yields across the German curve in the short run, especially if the ECB manages to re-affirm its credibility at its February meeting.

As for QT, we expect the ECB to announce some ‘technical’ details about the active selling flows starting in March (for example: sale will follow the capital keys) but there will not be further indications on how QT will continue beyond the second quarter of this year. We anticipate more details on QT to emerge only in March when the ECB will have more evidence on how the Eurozone financial conditions will look like with some additional policy tightening.