ECB View: A rate hike in 2024 is plausible, but only if the ECB is right about reflation – With financial markets fully focused on economic recovery, government bond yields have risen driven by expectations of ECB rate hikes over the coming years. In today’s daily we ask the question what is a reasonable timing for a first ECB rate hike and how does that chime with what is priced into financial markets.
The ECB gives guidance on the circumstances in which it will raise its key policy rates, but not on the exact timing. Unlike in the past, the central bank does not currently provide date-based forward guidance. Instead, the Governing Council signals that it ‘expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics’.
A fair starting point to judge when these circumstances might be met is the ECB’s own projections. However, the ECB’s projection period currently ends in 2023 so we have extended the period through to 2026 assuming that the trend it expects in core and headline inflation continues in the years thereafter (see chart below). This is obviously a rather simplistic assumption, but we judge it is a reasonable one for illustration purposes.
Source: Eurosystem and ECB staff macroeconomic projections March 2021, ABN AMRO Group Economics
On the basis that this picture will be realised and this is the outlook that the Governing Council will be faced with at any given point in time (big ifs but please bear with us), then a case could be made for a 2023 rate hike. In 2023, the ECB would then be expecting inflation to reach around 1.8% in 2025, which could roughly meet the definition of ‘close to, but below, 2%’. However, the condition that ‘convergence has been consistently reflected in underlying inflation dynamics’ would arguably not be met. This is because core inflation would not have risen by that significantly enough by that point and would be at levels (a little above 1%) that were consistent with the trends seen before Covid-19.
In addition, the ECB will later this year likely change the way it defines price stability. The ECB’s strategy review is currently scheduled to conclude in the second half of this year. The outcome of the review is uncertain but it looks very likely to shift towards a more ambitious inflation goal. In particular, numerous officials have signalled their support for a move from ‘close to, but below, 2%’ to ‘symmetry around 2%’. If this is the case, a mid-point projection of 2% within the ECB’s policy horizon would likely be the minimum condition for a rate hike. That would be the case in 2026 in our extrapolation exercise, suggesting that 2024 would be a reasonable timing for the first rate hike. By then, the ECB would also be more convinced about underlying inflation dynamics given a rise in core inflation to around 1.5%.
All this assumes that the ECB is right that a strong economic recovery will set the path for a gradual reflation and hence an upward trend in inflation in coming years. This would follow a correction (in 2021) of the temporary factors that have driven inflation up this year. However, one can have doubts about this reflation narrative. Despite the strong economic growth that the ECB projects for the coming years, an output gap will remain through towards the end of 2024. On that basis, assuming that underlying price pressures start to build from next year seems optimistic. Indeed, core inflation tends to be lower two years after a shock (for instance after the GFC and the euro crisis). We therefore think that the risks to the ECB’s inflation projections are skewed to the downside suggesting that a rate hike may not even materialise in 2024. Indeed, we think inflation will turn out lower than the ECB’s projections from 2022.
Markets are pricing in a more aggressive path for ECB rate hikes than seems likely on the basis of these considerations. One rate hike is priced in by 2023, three by 2024 and five by 2025. The pricing in of this rate hike trajectory has been the key factor in driving up Bund yields this year (see chart below). Over time, we think ECB communication and subdued inflation outcomes will lead to a re-pricing of rate hike expectations, which will drive Bund yields back towards the deposit rate. (Nick Kounis)
Expectations for short term interest rates and Bund yields, %
Source: Bloomberg, ABN AMRO Group Economics