Monetary tightening has likely peaked, but rates are likely to stay higher for longer
The effect of tighter policy continues to transmit through European economies, leading to notable easing in monetary supply by 2.9% MOM in March. Tighter liquidity and higher rates will continue to be a cause of significant economic headwinds and will complicate strategic planning in the medium term. MNCs and their partners will need to account for higher credit costs that will impact not only access to additional financing, but will also have a notable impact on demand. Trade in volumes across both business and consumer segments will likely ease through the end of June and remain stagnant through the rest of the year, while acute price pressures may result in increased competition pressures as customers continue to trade down for alternative goods or cheaper options.
- The European Central Bank (ECB) raised the main refinancing rate to 3.75% amid concerns regarding sticky inflationary pressures and signaled that more rates are likely, should inflation remain persistent.
- The Bank of England (BOE) followed suit and raised the key policy by 25 basis points to 4.5% on May 11, and it has signaled a more cautious approach going forward.
- The hikes come on the back of a milder-than-expected shock to European economies and suggest that central banks might have additional space for tightening, should the price environment necessitate it.
The recent hikes reflect persisting inflation but also come amid relatively strong performance of the service industries, which have been supported by strong nominal demand and a consumer spending shift away from goods and into services. The BOE’s recent hike likely reflects the peak of tightening, and monetary authorities have attempted to coordinate activities with industry representatives to prevent the need for additional tightening. Inflation at the start of H2 2023 should be half of the elevated 10.2% YOY in Q1 2023, which will ensure that rates remain elevated but should prevent additional hikes.
In our view, the ECB will likely maintain the current 3.75% rate through the end of 2023, but a relatively hawkish stance suggests that the risk of another 25-basis-point hike remains high. Economies across the eurozone have held up better than expected, but a drop in industrial output and weak retail sales suggest that growth across H2 2023 will remain largely flat. Regardless, the fact that most markets will evade a full-year recession gives the ECB a bit more room to tighten again, should core inflation in Q3 2023 remain substantially elevated.
Core inflation across Europe is unlikely to return to the central banks’ 2.0% YOY target. While we expect a series of small cuts in 2024 that will bring key policy rates to 3.0% by the end of the year, lending rates will remain historically elevated in the long term. Additional cuts in 2025 are likely, especially as headline inflation meets central banks’ targets, but a return to the ultra-low interest rates seen in the 2010s is highly improbable.
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