In front of the European Central Bank (ECB) east of Frankfurt, there is a stone monument inscribed with the words “European Central Bank – Eurosystem.”
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With less than two weeks left until the next European Central Bank meeting, European Central Bank policymakers appear undecided about the future of interest rates.
Financial markets are currently pricing in a rate hike at the April 29-30 meeting, followed by a June hike, according to LSEG data. A majority of traders expect the ECB’s key interest rate to reach at least 2.5% by the end of the year, an increase of more than 50 basis points (bp) from current levels.
German Bundesbank President Joachim Nagel said in an interview with CNBC Wednesday at the IMF Spring Meetings in Washington, D.C., that the ECB is “between a baseline and an adverse scenario” due to oil price fluctuations.
“The whole situation is very uncertain, very cloudy and we have to decide what happens next within two weeks,” he said, adding that “data is coming in every day in the form of news.”
Nagel said questions surrounding the reopening of the Strait of Hormuz were at the heart of the uncertainty, calling the vital waterway “the heel of the global economic system.”
“Any further uncertainty will impact the decisions we will make when we meet in two weeks,” he said. “(A) conference-to-conference approach is the right way to do it, and it’s the way we’ve always done it, and it’s even more important in these very complex times.”
Mr. Nagel suggested that policymakers were still considering the trajectory of interest rates.
“It’s really important to wait until you have all the information available on the day you have to make a decision,” he said. “This session-by-session approach is therefore the best way to conduct or conduct monetary policy.”
Nagel said inflation was expected to remain close to the central bank’s 2% target, but warned that if prices rise more than expected, it could prolong uncertainty and force a response from the ECB.
“We must remain as selective as we have been. Monetary policy should not exclude anything,” he said, again pointing to the Strait of Hormuz as key to decision-making.
“We have to be cautious here… From a monetary policy perspective, what happens over the next two weeks is something we still have to watch. A lot of new things could happen in the next two weeks, so I’m very cautious about properly indicating what the next steps are that we need to take on the monetary policy side.”
Shocking “layer cake”
Latvian central banker Martins Kazaks, a member of the ECB’s executive board, also told CNBC that policymakers were taking a meeting-by-meeting approach. When asked if April was too early to raise interest rates, he said, “We’ll see.”
“For example, what is happening in terms of the intensity of repricing? How does that ripple through to other areas of the economy?” He noted that core inflation in the euro area did not inch up in March.
Kazakhstan told CNBC that the economic shocks of 2020 and 2022, when the coronavirus crisis and Russia’s full-scale invasion of Ukraine shook the global economy, had heightened central bankers’ vigilance at a time when no one knows exactly how the war will end.
“No one knows if this shock will be followed by other shocks. The problem we’ve seen in 2020 and 2022 is that when shocks come… it’s like a layered cake,” he said. “Shocks overlap and interact. Some non-linearities can be triggered. And I think it’s very important for central bankers to be very careful and watchful to see what happens to those non-linearities. If those non-linearities occur, and I sometimes call it second-round effects, then we need to move.”
He added that Europe is currently in a “comfortable situation” but authorities will need to monitor data output as the situation develops.
“Eurozone markets are expecting two rate hikes starting in June,” he said. “At the moment I have nothing against it. Let’s see how it develops. But, of course, it will have to happen at some point. These non-linearities are certainly elements that we need to consider very carefully and, if necessary, act very quickly.”
At the end of March, ECB President Christine Lagarde said the central bank was prepared to raise interest rates even if the expected rise in inflation turned out to be temporary.
Lagarde told an audience at the ECB and its Monitors conference in Frankfurt, Germany, that if the shock were to cause a significant, albeit less sustained, overshoot of our (inflation) target, some cautious policy adjustment could be warranted.
“If such overshoots are left completely unaddressed, they can create communication risks. The public may find it difficult to understand a reaction function that does not respond.”
ECB is in ‘crisis mode’
“The ‘good thing’ about the ECB is no more,” Carsten Brzeski, global head of macro research at ING, told CNBC in an email on Thursday.
“Rather, the ECB is back in crisis mode, shifting its focus from long-term forecasts to actual developments and returning to a ‘driving on the horizon’ approach,” he said.
Key variables to watch include actual inflation data, survey-based long-term inflation expectations and wage trends, which policymakers will weigh against risks of a slowdown in economic activity and financial stability concerns, Brzeski said.
ING believes the ECB is anticipating an initial wave of inflation starting with gasoline prices and continuing with spillover effects to transport costs, food prices and industrial goods.
“As long as this remains a single, time-limited wave, there is no need for the ECB to raise interest rates,” Brzeski said.
“The longer the Strait of Hormuz is closed, the more likely we are to run into some problems. This is why we are now seeing the ECB announce at least one premium increase. Some would go so far as to call this a policy mistake.”
Antonio Alvarenga, a professor of strategy and entrepreneurship at the Nova School of Business and Economics, said ECB officials were being more cautious and conditional than usual in giving guidance.
“The ECB is approaching its April decision with an unusually wide and contrasting set of plausible scenarios, against the backdrop of slowing growth in major economies, persistent inflation trends and new upside risks to energy prices from tensions in the Middle East,” he said in an email on Thursday. “In that environment, being very specific can be costly because facts can change quickly before the meeting.”
Alvarenga added that central bank policymakers are leaning toward “reactive” communication that leaves them with maximum options for next action, and that “traditional forward guidance on likely paths has effectively faded.”
“[The war]changes what kind of guidance you can rely on,” he told CNBC. “The best they can do is communicate contingencies: ‘If inflation expectations unanchor or the energy-led second round effect increases, we’ll respond’ vs. ‘This is the path for interest rates.'”
“The trade-off with this approach is increased market volatility and widening dispersion of expectations. But from the ECB’s perspective, the bigger risk is that it is locked into a pre-announced trajectory and has to suddenly reverse it if the shock develops.”
