How Much Will the ECB Hike?

We can expect quite a bit of volatility on Thursday, when the ECB will make its rate decision. Surveyed economists are almost evenly split on whether there will be a 50bps or a 75bps hike. The market has priced in around 68bps, implying a favoritism towards the tighter policy. However, it’s still possible to get a bounce in the currency, since the move isn’t fully priced in.

Though part of the expectations could be influenced by an unusually large amount of debt issuance by Eurozone countries this week. Italy, Austria and Germany are all issuing bonds before the ECB meeting, which could put upward pressure on yields, and obscure how the market is really feeling about what will happen with the rate decision.

Putting the pieces together

There are good fundamental arguments for both positions, as might be expected. On the one hand, EU inflation is likely to keep rising after Russia cut off supply of gas through Nord Stream 1. Tighter policy might be justified in an attempt to prevent higher energy costs from spreading through the economy. On the other hand, that very possibility of higher energy costs could justify keeping rates on hold. Higher energy costs would contribute to a recession, thus lower prices, and less need for the ECB to take as aggressive attitude.

However, the reality is inflation isn’t on the “supply side” (that is, because of increased funds) as much as it is due to factors outside the ECB’s control. The ECB doesn’t control the price of energy, nor the flow of gas from Russia, nor the shutdown of factories because of higher energy and transportation costs. The ECB has one tool, and just because it might not be the most appropriate for the situation, it doesn’t mean they won’t use it, anyway.

The market reaction

There is wide expectation that the Fed will also hike rates by 75bps. Meaning that if the ECB goes for only 50bps, the gap between the Euro and the dollar will once again widen. That would put downward pressure on the EURUSD. On the other hand, a 75bps hike would simply maintain the gap, which could help the EURUSD, but would have less buoyancy.

The other factor to keep in mind is that ECB staff projections are announced at the same time. This could have a bigger impact on the currency, since forward expectations of rate hikes weigh more on institutional investors. Lately, there have been several ECB members emphasizing that they will push for tighter policy. Some have gone so far as to suggest that rates could go above the “neutral rate” in order to tamp down inflation. That would imply at least another 175bps of hikes over the next four meetings.

The future is what matters

Those aggressive stances might be tempered if the staff forecasts cut the outlook for the shared economy’s growth for this year and next. The last projections showed that the bank expected 2.1% growth for this year, and is likely to be revised downward. Inflation was also projected to be at 2% for next year, something that is likely to be revised upwards.

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