ECB surprises markets with hawkish pivot, despite lower rate hike

(Alliance News) - The European Central Bank caught investors unawares with a surprisingly hawkish tone on Thursday, despite stepping down the pace of interest rate hikes.

"While other major central banks made a slight dovish shift this week, the ECB staged a hawkish pivot," ING analysts said.

The European Central Bank on Thursday lifted its benchmark interest rate by 50 basis points, as expected, and warned there will be further "significant" rises to come.

The decision takes the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility to 2.50%, 2.75% and 2.00%, respectively, from next Wednesday.

While the half percentage point hike was in line with the moves of the Bank of England an hour before, and the US Federal Reserve on Wednesday, it was the ECB's markedly more hawkish rhetoric that spooked investors.

"While the rate hike of 50 basis points was widely expected, what came next was not, as Madam Lagarde adopted an almost Bundesbank assessment of what was going to come in respect of monetary policy next year," said CMC Markets' Michael Hewson.

Speaking at a press conference after the announcement, ECB President Christine Lagarde set out a hawkish outlook for future interest rate increases.

European equities dropped sharply upon the initial announcement, before falling further during Lagarde's speech. The CAC 40 closed down 3.1%, and the DAX in Frankfurt fell 3.3%.

It was a more volatile day in the foreign exchange markets, as traders digested the three interest rate decisions. The euro was trading at USD1.0613 by 1730 GMT, compared to USD1.0617 before the announcement. It was seen above the USD1.07 mark after the press conference, however.

Lagarde affirmed that interest rate hikes should be expected at a "50 basis point pace for a period of time".

The 50 basis point hike is the fourth interest rate increase this year. The ECB raised interest rates in July for the first time in 11 years, by half a percentage point, before following up with two 75 basis point hikes in its subsequent meetings.

"Not only did she outline the prospect of at least another 100bps of rate hikes between now and March, but the economic forecasts also made for grim reading," CMC's Hewson said.

The central bank expects the eurozone economy to grow by 3.4% in 2022, up from an estimate of 3.1% in September.

However, the ECB expects gross domestic product to grow by 0.5% in 2023, down from the September estimate of 0.9% growth. Its growth forecast of 1.9% in 2024 remains unchanged.

It also noted the possible the eurozone economy may contract in the current quarter and the first quarter of 2023. However, it noted any such recession would be "relatively short-lived and shallow".

However, the gloomy outlook also pervaded into the bank's inflation forecasts.

Eurosystem staff have "significantly" revised their inflation projects upwards, now expecting average inflation of 8.4% in 2022, before this eases to 6.3% in 2023, "with inflation expected to decline markedly over the course of the year".

Inflation is then expected to average 3.4% in 2024, before falling back to 2.3% in 2025

The forecast cut to growth and higher inflation forecasts means that "not only is Europe having to contend with the prospect of higher inflation, but also much higher rates", CMC's Hewson noted.

"While the eurozone economy is probably still the hardest hit of all major economies by the current energy prices and supply chain frictions, it has the central bank with the strongest determination to bring monetary policy into restrictive territory," ING considered.

The ECB also updated on the start of quantitative tightening.

"From the beginning of March 2023 onwards, the asset purchase programme portfolio will decline at a measured and predictable pace, as the Eurosystem will not reinvest all of the principal payments from maturing securities," the bank said.

The decline will average EUR15 billion each month until the second quarter of 2023, and the pace thereafter will be "determined over time".

"This degree of detail could also be interpreted as hawkish, because it reinforces the impetus to reduce the ECB’s balance sheet," Lloyds senior economist Hann-Ju Ho considered.

"It now looks as if the ECB will be devouring doves for Christmas dinner," ING analysts commented.

By Elizabeth Winter, Alliance News senior markets reporter

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