Schrödinger’s Door To Rate-Hikes

By Bas van Geffen, Senior Macro Strategist at Rabobank

It doesn’t make for a great optics when a central bank tightens policy only to see its currency drop straight after the decision. Last year, GBP did so several times after the Bank of England hiked against the backdrop of weaker growth forecasts. Yesterday, the EUR dropped despite the ECB’s decision to hike its policy rates by another 25bp.

This hike was never going to be a very hawkish one, considering that the Council’s doves were already opposing the rate increase to begin with. That said, we would not want to call it a very dovish hike either. The accompanying message was actually fairly balanced, and it was mostly the new staff projections that added some feeling of dovishness.

The ECB’s inflation outlook did not look significantly worse. At the same time President Lagarde told markets to expect some five quarters of sluggish growth, with gradual re-acceleration only in the course of 2024. As a result, the ECB slashed its growth projections. Despite these circumstances, the Council did not want to pause for more incoming data; they decided that a hike was needed to “reinforce the progress” towards achieving its inflation target.

It was never expected that the ECB would call the end of the hiking cycle. For one, the inflation outlook remains far to uncertain to say this with confidence, and pre-emptively calling it quits could cost the ECB its credibility. More importantly, if the upside were removed, markets would only be looking down from here. There were some hints suggesting that the ECB is done for now, although these came with plenty of caveats allowing the Council to extend the hiking cycle if needed. Asked whether the door to further hikes had now been closed or not, President Lagarde philosophically suggested that a door need not be either open or shut; Schrödinger’s door to rate hikes, if you will? Additionally, Lagarde emphasised that rates would have to remain restrictive for a sufficiently long period.

Rates markets seemed to ignore both of these caveats, though. There is very little priced in the way of further hikes, and money markets are increasingly pricing for rate cuts in 2024. While we also think that the ECB is probably done hiking rates, we can only emphasise that the near-term risks are still up and probably larger than markets are pricing. Yes, the growth outlook is not great, and the risk that the hiking cycle causes collateral damage is increasing. But the ECB demonstrated yesterday that weaker data do not dissuade it from further hikes, unless the slowdown also causes an improvement in the inflation outlook.

If any follow-up hikes materialize, it’s quite unlikely that this will happen in October. But risks surrounding the December meeting are still significant. Even though the ECB’s September projections are more reflective of the stagnation scenario we’ve pencilled in, the ECB staff is still more optimistic than we are regarding both the inflation and the growth outlook. Indeed, a couple of hawks told FT reporters today that strong wage growth and persistent inflation might warrant another hike in the final meeting of the year.

Wages remain an issue not only in Europe. Employees of three US carmakers have started industrial actions over a pay dispute. Factory workers are demanding a 36% increase in salaries over four years. The companies have so far offered up to 20%. Ford’s CEO warned that the pay demands would double the company’s labour costs related to workers who are member of the United Auto Workers union. Imagine that being passed on through higher prices; let alone in sectors where labour makes a bigger part of the manufacturing costs.

Either way, the strikes are illustrative of the still very tight labour market. And with US growth holding up better than we had expected to date, that tightness may persist for some time. The resilience of US consumers adds to this picture, although the Fed hikes are increasingly being felt. Retail sales softened in August, albeit by less than expected. That said, higher gas prices were a key factor behind the higher turnover, which adds to risks that other spending is being crowded out.

By contrast, China’s retail sales accelerated last month. Summer may have boosted this spending, as did higher prices for fuel. But the fact that these stronger sales came alongside an acceleration of industrial production sparked some optimism that the worst of the recent downturn may be over and that stimulus is catching on. That’s still a long stretch away from an actual recovery, though, and it remains to be seen whether the pick-up in e.g. sales can be maintained.

Weakness persists in various sectors and more stimulus may still be required to properly re-start the Chinese economy. The property sector in particular remains a sore spot, as evidenced by the further decline in property investment. Year to date, investments are down 8.8% y/y. In fact, weak housing sales suggest that the effect of recent policy changes intended to boost the property sector may have faded already.