ECB’s Razor-Edge Decision Rests on Price Outlook

The European Central Bank’s dilemma over whether to deliver a 10th straight interest-rate increase on Thursday hinges chiefly on how quickly its forecasts show inflation retreating.

(Bloomberg) — The European Central Bank’s dilemma over whether to deliver a 10th straight interest-rate increase on Thursday hinges chiefly on how quickly its forecasts show inflation retreating.

Updated projections for the euro zone through 2025 are now the most crucial input as officials choose to either pause their unprecedented monetary-tightening campaign or lift the deposit rate to a record 4%.

While only expected to shift a little, the new price outlook has the capacity to settle what’s become a cliffhanger of a meeting: 34 economists surveyed by Bloomberg predict a hold, while 32 foresee a hike. Money markets place two-in-three odds on another increase.

Any firm sense of the outcome within the Governing Council itself was also lacking going into the meeting, according to people familiar with the situation. Policymakers including Portugal’s Mario Centeno fret that another rise in borrowing costs would imperil Europe’s struggling economy. Others, like Slovakia’s Peter Kazimir, reckon inflation won’t revert to the 2% target without a further move.

President Christine Lagarde has kept her cards close to her chest since returning from summer vacation. She’ll brief the press in Frankfurt half an hour after the ECB’s 2:15 p.m. announcement.

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Interest Rates

Whatever the ECB’s decision, the accompanying statement is likely to retain language introduced in July that borrowing costs will be “set at sufficiently restrictive levels for as long as necessary” to ensure inflation returns to 2% in a timely manner. 

The phrase allows for potentially more hikes as well as an extended rate plateau, while pushing back against investors who see cuts materializing in the coming months.

Bank of France Governor Francois Villeroy de Galhau has long argued that the length of time borrowing costs remain elevated matters just as much as how high they eventually reach — if not more — and his views are increasingly finding support.

What Bloomberg Economics Says…

“While our base case is for a hike, it’s not a strong-conviction call. The economic slowdown, a turn in the path of underlying inflation, a probable end to the hiking cycle in the US and fears over China’s resilience could yet persuade the Governing Council to pause and take stock.”

— David Powell and Maeva Cousin. Read full preview here

Economists, though, predict a first reduction in rates in March, while financial markets have been betting on one next summer. 

“I disagree with that assessment,” Governing Council member Klaas Knot said in a recent Bloomberg interview. “Maybe we can push it out a little bit.”

Speculation on whether the ECB could narrow the gap between the deposit rate and the rate at which banks can borrow money for seven days has decreased recently. 

While such a decision would lower the relative cost of tapping the loans, it would probably also signal that officials are done with tightening and preempt the outcome of a broader review of how the ECB wants to conduct policy in the future. That exercise won’t be finished before year-end.

Economic Outlook

While the 20-nation euro zone continued to eke out growth in the second quarter, sentiment indicators suggest it’s since taken a turn for the worse.

Business surveys show services have started to follow manufacturing into a decline as sticky inflation takes a toll. Weak global demand and China’s slowdown are weighing on exports, while construction is dwindling in part due to higher financing costs.

That toxic mix has raised the specter of stagflation — even though the current situation differs greatly from the 1970s and 1980s, when unemployment shot up, in contrast to the record lows seen at present.

In a preview to the ECB’s projections, the European Commission cut its outlook for the region this week. The economy is now seen expanding just 0.8% this year and 1.3% in 2024, with a struggling Germany largely to blame. Inflation next year will probably be a touch faster than previously anticipated — with a projection by the ECB’s staff now expecting a number above 3%.

The Governing Council is likely to reiterate that it will continue to follow a data-dependent approach to setting policy, basing decisions on the inflation outlook, underlying price pressures and the pace at which past monetary tightening feeds through to the economy.

Other Matters

Aside from questions on the rate decision, Lagarde is likely to be quizzed on other developments from the two-day meeting of policymakers. 

On Wednesday, they voted to back the candidacy of Bundesbank Vice President Claudia Buch to lead the ECB’s banking supervision arm.

That’s a choice that may yet encounter friction in the European Parliament, where a panel of lawmakers in July determined Bank of Spain Deputy Governor Margarita Delgado to be the better-qualified candidate.

The legislature will need to ratify Buch’s nomination before a final sign-off by governments in time for her to succeed Andrea Enria when his non-renewable five-year term ends in December.

Lagarde may also face questions on an opinion issued by the Governing Council on Wednesday that warned of negative side effects from Italy’s controversial windfall tax on bank profits. 

That added a powerful voice to opponents of the retroactive measure, which may cost Italy’s five biggest lenders more than €2 billion ($2.2 billion), according to Bloomberg News calculations based on their assets.

–With assistance from Barbara Sladkowska, Harumi Ichikura and James Hirai.

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