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European Central Bank set to hike rates as it edges closer to a pivot point

Christine Lagarde, president of the European Central Bank.
Bloomberg | Bloomberg | Getty Images

FRANKFURT — The European Central Bank is set to hike rates once again on Thursday with market analysts certain that the Frankfurt intuition is nearing a peak despite inflation remaining stubbornly high.

The ECB will more than likely bring its main interest rate (its deposit rate) to 3.75% as economic indicators point to slowing of the real economy and loan demand slumping to a record low. But as a July hike is widely expected, the real question at this week’s meeting will be what will happen in September?

“We expect the ECB to follow through on the signaled hike this week to 3.75%,” said Mark Wall, a chief economist at Deutsche Bank, to CNBC. “The weaker than expected PMI data and bank lending survey highlight the Governing Council’s wisdom in leaving the outcome of the September policy meeting open,” he added.

The ECB has hiked rates by 400 basis points since July last year, which is the fastest tightening cycle on record for the central bank as inflation soared to record highs prompted by supply chain disruptions and an energy crisis sparked by the war in Ukraine.

This sharp rise in rates can have severe effects on loan growth in the euro area and thus on economic activity. “Firms’ net demand for loans fell strongly in the second quarter of 2023, dropping to an all-time low since the start of the survey in 2003,” the ECB said in a quarterly survey on Tuesday.

Banks play a dominant role in financing the economy in the euro zone as capital markets are not as liquid and deep as they are in the United States. The European Central Bank is seeing its tighter monetary policy rapidly take effect — especially via banking credit, ECB Chief Economist Philip Lane said in early July.

New data over the last few days has shown that euro zone business activity shrank much more than expected in July. Factory output declined at the fastest rate since Covid-19 first grounded the economy, and demand in the bloc’s services industry shrank as consumers grapple with high inflation. Germany’s Ifo Index also recently dropped more than expected.

What does this all mean for inflation?

Headline inflation fell more than expected to 5.5% in June, its lowest rate since the start of last year.

But core consumer prices, stripping out volatile elements like food and energy, rose 5.5% from a year earlier, according to Eurostat. That compares with a preliminary estimate of 5.4% and a reading of 5.3% in May.

“There are large differences among euro area countries in terms of inflation. In some countries, inflation has already fallen back below the 2 percent target, while in the Baltic region, inflation is only slightly below 10 percent,” Fritzi Koehler-Geib, a chief economist at KfW Group, said in a research note.

The ECB has to tread a fine line as it wants to convince the markets that it will keep rates at elevated levels for a long time despite a sharp cooling of the economy.

“The tone will remain hawkish, though,” Deutsche Bank’s Mark Wall concluded. “Inflation is still high and the ECB cannot be sure that rates are peaking yet.”

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