"New normal" in monetary markets, as European inflation up to 7% & ECB poised to hike again

Ten months ago, in July 2022, Europe officially transitioned into a new monetary cycle. That month, the ECB hiked interest rates from -0.5% to zero, signalling a new paradigm as inflation engulfed the continent. 

Today, the battle wages on, the main rate now sitting at 3%. 

This week, the market was treated to the latest all-important inflation numbers. According the preliminary data released Tuesday morning, headline inflation in the euro zone rose to 7%, up from 6.9% in March.  

While this sounds ominous, the 7% was in line with analyst expectations. More intriguing was the core inflation metric, which strips out the volatile effects of food and energy prices. The core number came in at 5.6%, below expectations of 5.7%. 

What kicks up the drama up a bit is that the latest monetary decision by the ECB comes Thursday, meaning these figures are the final inputs gained before the meeting. 

Will the ECB hike by 50 bps or 25 bps?

As has been the case for the guts of a year now, the market has its eyes trained squarely on Christine Lagarde, president of the ECB. Asset prices have been oscillating off expectations surrounding rate hikes ever since inflation began to ramp up, and it’s no different today. 

On the one hand, the headline figure is still lofty at 7%, and 10 bps above where it came in last month. This gives credence to forecasts of a 50 bps hike. On the other hand, the core number has fallen. Additionally, GDP data last week was disappointing, and weak loan demand data also came out this morning, both of which may tilt the scales towards a 25 bps hike. 

Banking issues could also play a part here. While the Credit Suisse chaos of last month has largely been weathered well, with the market calming and the worst of the crisis seemingly over, First Republic Bank failed in the US last week after revealing the extent of its first-quarter outflows. This could give the ECB food for thought. While the US bank has nothing to do with Europe, Credit Suisse’s imposition came off the back of the Silicon Valley Bank insolvency stateside, and banking turmoil is by its very nature a confidence game. 

In truth, we can speculate as much as we want either way, but I like to lean upon the oft-repeated saying in these spots: numbers don’t lie. Why listen to my speculation when we can just check the probabilities implied by the money market? And that money market has a near 90% chance of a 25 bps hike, up from 74% on Friday, as demonstrated on the below chart. 

What will happen long-term?

While the money market gives us a pretty good indication of what happens next, the long-term picture remains murky in the euro zone. Inflation is still far beyond the 2% target, and regardless of whether it is a 25 bps or 50 bps hike, that target won’t be hit anytime soon. 

The reality is that the continent needs to deal with inflation north of that 2% target for a while – until 2025, if recent IMF figures are to be believed. Even when thinking of the most ambitious scenarios, it is hard to imagine that inflation is not highly elevated for at least another year. 

The US in the 1970s, while a totally different climate for a variety of reasons, presents as a cautionary tale here. Inflation was seemingly tamed three times, before roaring back stronger, until it was finally “beaten” for good. This should warn against the perils of paring back from high rates too soon. Even if the hiking cycle slows, it feels a reach to predict the ECB will begin cutting back down to the basement-levels seen for much of the last decade. We were told frequently about the “new normal” over the past couple of years, right? It may be time to apply that phrase to monetary markets. 

 For now, the markets will tune in Thursday for the latest twist in the tale, with 25 bps leading the charge as we come down the home stretch. 50 bps still has a chance, but if it did fall that way, expect a strong sell-off given 25 bps is very much priced in as the current expectation. 

Beyond that, it’s harder to say. The ECB’s main job is the same as previously: toe that line between recession and inflation. That is, hike rates enough so that inflation is reined in, but so much that a nasty recession is triggered.

A much-fantasised soft landing is the promised land. Whether that narrow escape route can be found, however, remains to be seen.