An important week has passed with the ECB making its stand on inflation and in backstopping fragmentation risk. The Fed will have its say next week but as central banks remain focused on bringing down inflation, markets are likely to focus on growth risks given the contractionary readings in the July PMIs in the US and euro area.
ECB hikes rates; announces new transmission tool
With headline inflation running at 8.6%Y/Y in June and the core rate confirmed at 3.7%Y/Y, "undesirably high" inflation prompted the ECB to hike rates for the first time in 11 years this week. The reports in the days prior to the meeting proved correct as the Governing Council went against its earlier guidance to deliver a larger hike of 50bps to its 3 key rates instead of 25bps. The particular significance of 50bps is that it lifts the depo rate (rate paid on banks' overnight deposits) straight back to 0%, accelerating the exit from a 7-year period of negative settings. It has also meant that the ECB has thrown in the towel on forward guidance on future interest rate moves, with the statement noting it will now take decisions on a "meeting-by-meeting" and data-dependent approach. President Christine Lagarde was clear at the press conference that "further normalisation" of rates is to be expected at upcoming meetings; however, the window for those hikes could be closing given a deteriorating growth backdrop as the euro area's composite PMI fell into contraction in July.
In what has generally been viewed as a compromise solution, the council has agreed to a larger rate hike upfront given the inflation situation while the dovish members have secured the addition of the Transmission Protection Instrument (TPI) to the ECB's toolkit. The TPI will stand as a backstop to guard against "disorderly market dynamics" interfering in the implementation of the ECB's monetary policy stance. The widening of Italian yield spreads following the collapse of its government appears unlikely to be viewed in this context. That being said, the accompanying release clearly leaves the ECB with a large degree of discretion to determine what would activate asset purchases under the TPI, while it says the size of such purchases is "not restricted ex ante".
All euro area countries can qualify for TPI support if the ECB deems it appropriate, though some conditionality has been attached to that commitment, relating mainly to complying with existing EU fiscal rules and having "sound and sustainable"macroeconomic policies in place. Regardless of the formulation of the TPI, the ECB asserts that its "first line of defence" in preventing what it sees as an unwarranted widening of yield spreads will be to use the flexibility it has built into the reinvestment phase (which it is now in) as bond purchased in the PEPP (pandemic-related) program mature. PEPP holdings stand at €1.7tn and the ECB has committed to a reinvestment phase through to the end of 2024 at the least.
Rising inflation risks a more aggressive BoE
UK inflation surprised to the upside of expectations to print at 9.4%Y/Y in June. The peak is not likely to come in until later in the year as there is another increase in household energy prices coming through in October, and when it does the Bank of England anticipates inflation will be running above 10%. Meanwhile, the core rate matched estimates in easing from 5.9% to 5.8%Y/Y.
When taken with the inflation data, this week's report on the labour market may well bring the BoE round to market pricing, which anticipates a step up to a 50bps rate hike in August after a series of smaller increases. A speech from BoE Governor Andrew Bailey confirmed that a 50bps hike will be under consideration at the next meeting, with the emphasis being around guarding against high inflation becoming entrenched by feeding through to the wage setting process. The UK labour market looks robust, with the unemployment rate holding at 3.8% in May and remaining below its pre-Covid level. Demand for labour is strong, highlighted by employment rising by a stronger-than-expected 296k for the most recent 3-month period while job vacancies - despite softening over the quarter - are also very elevated. With labour supply in the UK being restricted by the effects of Covid, a tight labour market has pushed up annual earnings growth to 4.3% compared to a pre-Covid pace of around 3%.
RBA ponders neutral rates in Australia
Since the May meeting when the RBA started hiking rates, its justification has been that the economic conditions no longer require emergency support and it has been in the process of normalising monetary policy. Assuming normalising means returning the cash rate to a so-called neutral setting (neither expansionary or contractionary for economic activity), the July meeting minutes showed the Board had a preliminary discussion around what this level might be. The key observations were that the cash rate was "well below" estimates of the neutral rate and that if inflation expectations were to shift upwards then more rate hikes would be needed to return inflation to the target band than otherwise.
A speech by Governor Philip Lowe gave further insights, with RBA research tentatively suggesting the real rate of interest was positive. If inflation expectations are anchored at the midpoint of the 2-3% target, Governor Lowe said that would imply a neutral nominal cash rate of "at least 21⁄2 per cent". Building on analysis from the Financial Stability Review, Deputy Governor Michelle Bullock said household finances were well positioned to cope with the current tightening cycle. Next week sees the focus centred on the Q2 inflation report where the median estimate for headline CPI is 6.2%Y/Y and 4.7%Y/Y on the trimmed mean. Market pricing points to a 50bps rate hike in August, with only a small chance being given to a surprise 75bps increase.