Walk and then?: five questions for the ECB

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

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

“The difference (with previous meetings) is that so far they have given at least fairly precise guidance regarding the next meeting,” Barclays’ head of European economic research Silvia Ardagna said. “And we expect that to get looser.”

Here are five key questions for markets.

1/ How much will the ECB raise rates?

Markets price in a quarter-point increase to 3.75% and economist forecast.

Headline inflation is cooling, but remains high enough to warrant a modest increase. The ECB has signaled a July move.

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

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

Market consensus for one more hike after July is no longer rock solid after a few ECB hawks suggested that a September increase is not certain, so the ECB could become more cautious in its signals, while confirming that it will depend on the data.

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

Some analysts expect the ECB to pause in September, when updated staff forecasts will give it a chance to signal that inflation is ready to hit its 2% target.

They added that they wouldn’t be surprised if the ECB paused then and raised later if necessary, as the US Federal Reserve has. They priced money markets one more hike after July, suggesting rates will top around 4%.

3/ When does the ECB expect core inflation to come down?

While headline inflation fell for the third straight month in June, so-called core prices, such as those for services, have risen stubbornly and are not expected to abate anytime soon.

Core inflation, seen as a better indicator of the underlying trend, only dipped to 6.8% from 6.9%, far from the sustained decline rate setters want to see.

ECB chief Lagarde will likely come under pressure on this question, but may not reveal much ahead of new economic projections in September.

“Core inflation will be very, very slow to come down, so this is a concern for the ECB,” UBS chief European economist Reinhard Cluse said, pointing to a tight labor market and wage pressures.

4/ What does a weakened economy mean for politics?

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

“I think (the weakening economy) will have a minimal impact on monetary policy,” said Rubén Segura-Cayuela, Europe economist at BofA. “What matters for the September meeting will be core inflation.”

Still, the growth slowdown could strengthen the pigeons’ hands. Eurozone business activity stagnant in June, when the manufacturing recession deepened and a previously resilient services sector barely grew.

BofA considers that the forecasts of the ECB are too optimistic; Barclays forecasts a multi-quarter stagnation starting in the second half of 2023.

5/ What impact is a tighter policy having on financing conditions?

Bank lending data suggests the steepest rise in borrowing costs in ECB history has started to affect credit conditions and the latest figures for July 25 are in the spotlight.

ECB Chief Economist Philip Lane says loan volumes have weakened dramatically and that this may result in a “substantial” decline in economic output.

This dovish message, if reinforced by the latest bank lending data, may fuel speculation that rates are close to peaking.

“The maximum impact of the tightening of financing conditions will be at the end of this year and the first half of 2024. Therefore, much of the effect has yet to come,” said Segura-Cayuela of BofA.

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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