The ECB will raise the deposit rate by 25 basis points this week, a decision that had already been widely communicated since March. During the ECB Watchers Conference held in March, President Lagarde emphasized that a moderate adjustment of interest rates would be necessary. This was a clear signal to financial markets that a rate hike was imminent. The only remaining questions concerned the timing and magnitude of the increase, not whether it would happen.
Following the conflict in the Middle East, financial markets are primarily concerned about inflation and how it will influence the ECB’s response. Every significant increase in oil prices leads markets to price in further rate hikes. However, there are reasons to believe that markets are overestimating the ECB’s restrictive stance.
The ECB’s communication regarding rate hikes in response to the oil shock has indeed changed compared to the past. Normally, ECB communication is characterized by a variety of differing opinions, generating considerable uncertainty about the future path of rates, even in the presence of strong economic shocks. This time, however, most members of the Governing Council seem to have spoken with one voice, adopting a very similar line. This was likely intentional, to help stabilize inflation expectations among businesses and households.
However, financial markets have interpreted this uniformity in communication as a signal that the entire Governing Council has become particularly aggressive in fighting inflation. This is unlikely to be the case. More importantly, the risks related to a weakening real economy are being underestimated. Although survey-based indicators have shown a significant deterioration since the start of the conflict, markets continue to ignore this data. The ECB, on the other hand, will pay attention to it.
Overall, although the ECB will raise rates by 25 basis points at this meeting, financial markets appear to have gotten ahead of themselves in their expectations. The risks to the real economy are underestimated, just as the perceived rigidity in the ECB’s communication is overestimated.
The ECB could therefore surprise markets by adopting a more balanced and dovish communication than currently expected.
