Vanguard: ECB would be wise to raise interest rates

September 13, 2023

The European Central Bank would be wise to raise interest rates tomorrow by 25 basis points, bringing the deposit facility rate to 4.0%. This is because core inflation remains stubbornly high and markets fear that it will rise again, partly due to the recent increases in commodity prices.

This is what Shaan Raithatha, Investment Strategist at Vanguard, said in a preview of the meeting of the European Central Bank on Thursday, September 14. Still, Vanguard wouldn't be surprised if a pause is announced given a sharp deterioration in economic activity. Moreover, a break is the path of least resistance. The asset manager does not expect any interest rate cuts until H2 2024.

Since the July meeting, euro area growth has slowed meaningfully. August’s manufacturing PMI came in at a miserable 43.5, marking 14 straight months of readings below 50. Meanwhile, the August services PMI shrank to 47.9 from 50.9 in the previous month.

Forward-looking components of the surveys (new orders, new export orders, incoming new business) suggest there is more pain to come. The hard data has held up slightly better, though retail sales and trade data for July both came in weak. Credit conditions continue to deteriorate too, with corporate interest payments rising significantly, money supply (M3) now contracting, and a deeply negative credit impulse.

Moreover, fiscal policy is likely to be a net drag this year as energy support to households unwind (in contrast to the expansionary stance in the U.S.). It is therefore likely that the ECB will materially downgrade its 2023 growth forecast tomorrow from 0.9% to closer to our 0.5% call. 

Inflation data

The inflation data has been more mixed. Headline CPI surprised slightly to the upside in July, with the annual rate standing at 5.3%. Core prices also remain frustratingly sticky, though services inflation did slow for the first time in months.

We don’t expect any meaningful changes to the CPI staff projections, though the recent rise in both crude oil and natural gas prices poses upside risks of second-round effects re-asserting themselves. The labour market remains tight, with the unemployment rate at a cycle low of 6.4%. However, we expect this to tick-up towards 7% over the coming quarters as the recession sets in. 

Recession

It will be a close call, but on balance we think the ECB should hike once more by 25 basis points given the still uncomfortably high run-rate of core inflation. Risk management considerations are also in play given the recent rise in commodity prices and up-tick in both survey and market-based measures of inflation expectations.

That said, we do see compelling reasons for a pause too. The economy appears to be heading into recession in H2 2023, with both the impulses from contractionary monetary and fiscal policies biting. A pause is also the path of least resistance, with markets pricing in a higher chance of ‘no action’ than not on Thursday.

Finally, there is also the possibility of a ‘Hawkish Hold’, in which a pause in rate hikes is the compromise made for a more aggressive path of balance sheet contraction in the coming months. 

Whatever happens, it is likely that after Thursday, the ECB has reached its ‘terminal’ rate for this cycle. In our base case, we expect rates to be held at this level until at least the second half of 2024, before a gradual easing cycle begins.