ECB rate hike risks triggering a rapid economic slowdown: PGIM Fixed Income

by | Sep 18, 2023

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Analysis from Katharine Neiss, chief European economist at PGIM Fixed Income

The ECB raised its deposit rate to 4% last week, an all-time high since the launch of the euro. It cited uncomfortably high headline inflation of more than 5% as the key driver of its decision. Higher interest rates signal concern among ECB policymakers that underlying inflation could become embedded. This would make it harder to get back to the bank’s 2% target.

Despite the backdrop of uncomfortably high inflation, the ECB recognised the euro area economy is cooling. So, reflecting the recent data flow, it downgraded its outlook for GDP growth to 0.7% in 2023 and 1% in 2024. It maintained its projection for underlying inflation in 2023 at 5.1% and lowered its projection for 2024 to 2.9%. These downgrades are a strong signal interest rates are unlikely to rise further.

 
 

That said, the bank is keen to message that interest rates will need to remain higher for longer. We therefore do not expect rate cuts until the data reveals a compelling downward trend in underlying inflation.

The ECB lowered its outlook for GDP growth in 2024 to 1%, but we view this as still too optimistic. Economic activity is weakening across the board, and the manufacturing slowdown is spilling over into services. Our base case calls for GDP growth of 0.5% in 2024, which is below consensus and half the ECB’s forecast. Indeed, yesterday’s hike could tip the economic balance: it risks triggering a rapid economic slowdown and below-target inflation in the medium term.

To top it off, President Christine Lagarde said there had been no discussion of ending the bank’s pandemic emergency purchase programme (PEPP) reinvestments. This was a less forceful reply than we had expected in light of investor nervousness towards Italy.

 

Looking ahead, our base case is for stagnant growth in the euro area, coupled with high inflation and limited relief in terms of lower ECB rates. How the economy evolves from here is highly uncertain, but in our view, the balance has shifted to the downside.

Guillermo Felices, global investment strategist at PGIM Fixed Income, adds:

“In the near term, Thursday’s ECB decision may, counterintuitively, support bond markets. It signals a serious commitment to fighting inflation in the face of weakening euro area growth. That puts a lid on term yields and helps reduce volatility in European government bonds. Separately, robust US activity is helping global risk appetite.

 

“European risk assets, including corporate bonds, may well benefit from that combination: lower volatility means tighter euro spreads and higher equity prices.

“But the ECB’s decision to hike in the face of weak growth raises questions about possible medium-term damage to the euro area economy. Is the ECB overtightening? Probably. But, for now, risk markets are pushing that problem down the road. Investors dislike inflation-related volatility, so the less of that, the better.”

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