I’ll preface this note by saying what I’ve said for some time now, that hiking rates into a negative demand shock is the very definition of a policy mistake, and hence is not a path that policmakers should go down.
However, considering that I am sat here typing this note, and not sitting on a policymaking committee of a G10 central bank, what I think they should do matters little from a trading perspective. Instead, what matters is what they will do.
A June ECB Hike Is On The Cards
Speaking of which, it seems all-but-guaranteed that the ECB will now deliver a 25bp depo rate hike at the conclusion of the June meeting. While the Governing Council’s hawks have pushed for such a move for some time now, and sources stories have long indicated that it is on the horizon, even the ECB’s more dovish members, such as Chief Economist Lane, appear to now be waving the white flag, having resigned themselves to a rate hike being delivered.
Keen historians, of course, will note that we have been here before. Twice, in fact! In 2008, under Trichet, the ECB found themselves raising rates in reaction to higher energy prices in the summer, before the GFC struck mere months later. Then, in 2011, history repeated itself, as policy was tightened right on the brink of the sovereign debt crisis. Somehow, I can’t imagine this being a case of ‘third time lucky’, and am instead reminded of how it is often said that the definition of insanity is to do the same thing over and over again, while expecting a different result.
An ‘Insurance Hike’ Would Be Counter-Productive
Monetary history lesson aside, what troubles me most about the ECB’s seemingly inevitable upcoming rate hike is a prevailing wisdom that such a move could be ‘one and done’, framed as more of an ‘insurance’ measure than anything else.
The problem with this, though, is that by hiking once, the deposit rate would remain within the range of estimates of its neutral level, at 2.25%. Consequently, while policymakers may frame such a move as being aimed at ensuring inflation expectations remain well-anchored, and bearing down on potential risks of second-round inflationary effects, it seems unlikely that either would be achieved.
Instead, in delivering such a modest tightening, the ECB would likely find themselves in something resembling the worst of all worlds - tighter policy would act as a further headwind to already-anaemic growth momentum, but policy would likely not be tight enough to bear down on perceived upside inflation risks. A compromise solution to try and please the Governing Council’s hawks and doves alike, would instead likely end up pleasing nobody at all.
Lagarde Should ‘Go Big’ Or ‘Go Home’
As such, for President Lagarde and her colleagues, it seems very much as if this is a scenario where they must either ‘go big’, following the likes of the RBA and embarking on a tightening cycle; or, they must ‘go home’, following the BoE and the FOMC in adopting a ‘wait and see’ approach, with rate hikes on the backburner for the time being.
From a market perspective, the ECB continuing to follow this ‘middle of the road’ approach is one that likely poses chunky downside risks to the EUR. Not initially, perhaps, given that there would likely be knee-jerk upside in the common currency if/when a hike does come to pass at the June meeting, though more likely over the medium-term as participants are forced to price something resembling a more ‘stagflationary’ eurozone economic outlook.
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