In response to some of the highest inflation rates since the 1970s, the ECB‘s main refinancing rate has risen from zero in June 2022 to 4.5% in September 2023, while the deposit rate rose from -0.50% to 4%.
The decision not to tighten policy further was in response to a weakening eurozone economy, as manufacturers struggle with weakening domestic and external demand, while services companies are also reporting slower activity.
The inflation rate has also moderated substantially in recent months, falling from a peak of 10.6% y/y in October 2022 to 4.3% y/y in the latest data release in September. Much of this fall was caused by the impact of higher energy prices last year dropping out of the annual comparison of prices. Inflation is expected to fall further, but ECB president Christine Lagarde suggests that risks were skewed towards higher inflation.
Lagarde said: “Inflation is still expected to stay too high for too long, and domestic price pressures remain strong.”
But in reference to the decision to hold, she said: “We are determined to ensure that inflation returns to our 2% medium-term target in a timely manner. Based on our current assessment, we consider that rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target.”
Although there was no indication that further rate rises were off the table, the language used suggests that the ECB would need to see a significant deterioration in the inflation outlook. Indeed, the decision to keep policy on hold was largely expected by financial markets.
Looking ahead, the next policy move is likely to revolve around the ECB’s balance sheet, and the pace of the unwind of support. Upward pressure on bond yields of late were blamed on “external factors”, but it is clear that the ECB still has one eye on the ability of countries, particularly Italy, to fund itself in an affordable and orderly manner.
As for interest rates, the next move is likely to be a cut, probably in 2024. How soon and by how much in the coming year will depend on the progress made to lower inflation back to target.
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