The ECB hikes by 25bp, with more to come

As seemed likely for some time, the ECB raised the policy rate by 25bp from 2¼% to 2½% in a “unanimous” decision, which President Lagarde colourfully said was a “no-brainer”, stressing that it was a “robust” decision when judged across the various economic scenarios prepared by ECB staff.

• No forward guidance, but the base case points to at least another hike by the end of this year.
  President Lagarde did not offer forward guidance, saying that “we have not actually debated at all any kind of future path”. CCI's policy rule, based on the updated central scenario, still points to another rate rise, which would take the policy rate to 2¾%, possibly in October depending on events in the Middle East, but probably in December when the ECB next updates its outlook.

• The ECB could easily raise rates to 3% or more by mid next year given upside risks to persistent above-target inflation and a higher neutral policy rate.
  At 2½%, the policy rate is now at the upper end, or slightly above, the various estimated ranges for the neutral policy rate. The risk is that the ECB raises rates to 3% or more given:
  (1) persistent above-target inflation, where inflation has “in a way [been] lower than we had anticipated … but we believe that inflation will be longer lasting than we had anticipated”, with staff estimates showing core inflation ending the forecast horizon at 2.3%;
  (2) the obvious upside risks to inflation from the Iran war; and
  (3) the risk of a higher neutral rate. Lagarde downplayed the usefulness of the neutral rate because “you cannot actually pinpoint the [time-varying] neutral rate … because it is supposed to be defined in times of no shock and we are constantly under shocks”. The market is pointing to the risk of a sharply higher neutral policy rate, in that the global sell-off in bond markets reflects higher term premia and higher expected short-rates, where the latter approximate the neutral policy rate.

• The ECB’s base case incorporates marginally higher and more persistent inflation, as well as historically low unemployment.
  The ECB published a central case for the outlook, as well as upside and downside scenarios that hinge on assumptions for energy prices. In the central case, core inflation is forecast to be 2.6% by end-2026 (unchanged from the June outlook), edging down to 2.4% by end-2027 (previously 2.3%) and then 2.3% by end-2028 (2.2%). Unemployment is forecast to edge down to 6.2% by end-2026 (previously 6.3%), reaching 6.1% by end-2027 (unchanged) and 5.8% by end-2028 (5.9%).

• High bond yields reflect demand for credit from the tech sector and US fiscal policy.
  Rising global bond yields reflect demand for credit from the tech sector, where financing has spilled over from equity to bonds and private credit. Lagarde said that the US market “is also playing a role”, which likely points to extremely high and rising public debt. She was careful not to criticise recent US interventions in FX and bond markets, stating only that there are spillovers to other markets.

• Cancelling public debt held by the Bank of France is a non-starter.
  Lagarde sharply criticised the idea put forward during French election campaigning of cancelling government debt held by the Bank of France, noting that it was illegal under the Treaty on the Functioning of the European Union.