Will the ECB slow its interest rate hikes as euro zone inflation cools?

LONDON, July 24 (Reuters) – The European Central Bank looks set to pull the trigger on a rate hike on Thursday, but what it will do after July is less certain and financial markets are craving some guidance.

Euro zone interest rates rose 400 basis points last year to 3.5%, their highest in 22 years, and are now close to peaking as headline inflation cools and the economy weakens.

“The difference (from previous meetings) is that so far they have given at least accurate guidance vis-a-vis the next meeting,” said Barclays head of European economics research Silvia Ardagna. “And we expect to be more relaxed.”

Here are five key questions for markets.

1/ How much will the ECB rate increase?

A quarter percentage point increase to 3.75% was priced in by markets and predicted by economists.

Headline inflation has cooled but remains high enough to justify a modest increase. The ECB has flagged a move in July.

“The ECB will hike again and anything else would be a big surprise,” said RBC Capital Markets global macro strategist Peter Schaffrik.

2/ What signals is the ECB likely to send regarding future policy?

The market consensus for another hike after July is no longer rock solid after some ECB hawks suggested that the increase in September is uncertain, so the ECB may be more cautious in its signaling, while confirming that it will depend on the data.

“(ECB President Christine) Lagarde will emphasize uncertainty and conditions (when and if she talks about further tightening),” said Massimiliano Maxia, senior fixed income specialist at Allianz Global Investors.

Some analysts expect the ECB to stop in September, when updated staff forecasts give it an opportunity to announce that inflation is set to reach its 2% target.

They added that they would not be surprised if the ECB pauses later and hikes later if necessary, as the US Federal Reserve has done. The price of money markets in another increase after July, which suggests that the rates will rise to around 4%.

3/ When does the ECB expect core inflation to fall?

While headline inflation fell for the third consecutive month in June, so-called core prices, such as those for services, rose sharply and are not expected to stop soon.

Core inflation, seen as a better gauge of underlying trends, eased to just 6.8% from 6.9% – far from the sustained drop rate-setters wanted to see.

ECB chief Lagarde is likely to be pressed on this question but may not give too much away before the fresh economic projections in September.

“Underlying inflation will fall very, very slowly so this is a concern for the ECB,” said UBS chief European economist Reinhard Cluse, noting a tight labor market and wage pressures.

4/ What does the weakening economy mean for policy?

Well, rate-setters reiterated that the primary focus remains inflation, even if monetary tightening hurts the economy.

“I think (the economic weakness) will have little impact on monetary policy,” said Ruben Segura-Cayuela, BofA’s European economist. “What matters for the September meeting is core inflation.”

However, slow growth strengthens the hands of pigeons. Euro zone business activity ground to a halt in June as a manufacturing recession deepened and a previously buoyant services sector barely grew.

BofA considers the ECB’s forecasts too optimistic; Barclays expects a stagnation in several quarters starting in the second half of 2023.

5/ What is the effect of a tighter policy on financing conditions?

Bank lending data suggests that the highest increase in borrowing costs in the history of the ECB is starting to take a toll on credit conditions and the latest figures for July 25 are in focus.

The ECB’s chief economist, Philip Lane, said loan volumes had weakened significantly and this could create a “significant” reduction in economic output.

This dovish message, if reinforced by the latest bank lending data, could prompt speculation that rates are about to rise.

“The peak effect of the tightening of financial conditions will occur at the end of this year and in the first half of 2024. So more effects should come,” said BofA’s Segura-Cayuela.

Reporting by Naomi Rovnick and Dhara Ranasinghe in London and Stefano Rebaudo in Milan, Graphics by Vincent Flasseur, Sumanta Sen, Pasit Kongkunakornkul, Kripa Jayaram, Editing by Catherine Evans

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