On Thursday 4 May, the governing council of the European Central Bank will convene to decide on the ECB’s three banking rates. Analysts from Bloomberg, ING and Pictet wealth management predict that a 25 basis point increase is more likely.
The statistics agency of the European Union, Eurostat, published the flash estimates for April on Tuesday, providing the latest salvo ahead of the ECB’s key decision tomorrow.
“We are targeting an inflation rate of 2% over the medium term,” the ECB has restated, and given that headline and core inflation have remained practically the same as a month before--and are substantially high, at 7% and 5.6%, respectively--the governing council might be persuaded to pursue a more hawkish monetary policy.
Here is a summary of the current state of affairs.
Core inflation, which excludes the contribution of food and energy prices from the consumer price index, which are often subject to large fluctuations due to supply and demand factors beyond monetary policy, remained consistently high. It dropped a notch to 5.6% in April 2023, compared to 5.7% in March.
However, while it was reasonable to base policy decisions on core inflation alone when energy prices were highly volatile, they have now subdued significantly. Therefore, core inflation alone is no longer the major factor in decision-making. This was also emphasised by a board member of the ECB, Isabel Schnabel: “People talk a lot about a potential peak in core inflation. I would not overemphasise the peak as such, because what really matters is that inflation is returning to our two percent target over the medium term.”
However, as it stands, the overall inflation rate in April increased to 7.0%, compared to 6.9% in March. Furthermore, inflation rates varied widely across the 20 member euro area, with Luxembourg reporting the lowest rate at an estimated 2.7%, while four members reported rates higher than 13%.
As inflation outpaced wage increases, real income per capita in Q4 2022 was down in both the euro area and the EU, by -0.5% and -0.3% respectively. Negative real wages also impacted household consumption, which dropped by 1.2% in the euro area and 0.9% in the EU.
In contrast, gross disposable income increased by 2.2% and 2.4% in the euro area and EU, respectively, compared to Q3 2022, leading to an increase in net savings rate by 0.8% and 0.6%, respectively. In other words, households postponed some key spending, and a portion of disposable income went to savings.
In April, Luxembourg’s central bank (BCL) reported that the consumer confidence indicator experienced a sharp decline compared to March 2023.
The preliminary flash estimate for the first quarter of 2023 indicates that seasonally adjusted GDP increased by 0.1% in the euro area and by 0.3% in the EU, which is a healthy increase compared to the previous quarter when GDP remained stable in the euro area and decreased by 0.1% in the EU. The year-on-year growth rates were positive for all countries except for Germany (-0.1%), indicating that the expected dampening effect of high interest rates has not yet taken hold.
Post-pandemic immigration to EU jumped by 18% in 2021, leading to the growth of businesses and a new labour force. However, with a historically low unemployment rate of 6.6% across the euro area in February 2023, indicating a tight labour market, the ECB is likely to continue an aggressive monetary policy to further cool the economy.
It should be noted that a tight labour market typically leads to upward pressure on wages and prices, which in turn contributes to inflation.
The US Federal Reserve has increased policy interest rates nine times, totaling 500 basis-points, while the ECB has increased interest rates five times, totaling 300 basis-points, in less than a year. The current interest rate spread between US federal rates and the ECB’s deposit facility rates is 200 basis points, providing investors with a higher return in the US compared to the eurozone.
It is worth noting that the Federal Open Market Committee members considered a 50 basis point increase in the absence of the negative developments in the US banking sector in their 21-22 March meeting, settling for a 25 basis-point increase instead, indicating a stronger willingness to contain inflation, even at the cost of banking sectoral turmoil.
This interest rate differential also affects the dollar-euro exchange rate, as a higher interest rate in the US than in the eurozone for an extended period of time could eventually lead to dollar depreciation against the euro. This would have an impact on euro area imports. In light of high inflation, a smaller interest rate differential might seem like a preferable option to prevent the euro from appreciating too much. The euro was trading at par with the US dollar in July 2022 but appreciated to $1.0981 as of Friday 28 April.
While it remains an open debate until Thursday afternoon, governing council member Schnabel, tipped: “Data dependence means that 50 basis points are not off the table.”