European Economy: ECB Rate Hike May Still Be Some Way Away

■ At the March ECB meeting, focus will be on President Lagarde's response to interest rate hike expectations and the scenario analysis of macroeconomic forecasts.  

■ Unlike the inflation shock of 2022, the ECB is expected to continue its "data-driven, meeting-by-meeting" stance for the time being. 
 
The ECB Governing Council meeting, scheduled for March 18-19, is expected to maintain the policy rate unchanged. The focus of this meeting will be President Lagarde's remarks at the press conference and the staff's macroeconomic forecasts. With tensions in Iran driving up energy prices, Slovak Central Bank Governor Kazimir stated that "we are prepared to take action, if necessary, at the April or June meeting," and the market has largely priced in a roughly 70% probability of an interest rate hike before July. President Lagarde is expected to continue to reiterate her data-driven, meeting-by-meeting stance amidst high uncertainty, but how she responds to the market's rising expectations of interest rate hikes will be closely watched. 
 
In the staff's macroeconomic forecasts, economic growth is expected to be revised downwards and inflation upwards, but the baseline forecast may only be slightly adjusted. It is worth noting whether the ECB will release scenario analyses based on different crude oil price assumptions. Previously, in December 2023, amidst instability in the Middle East, the ECB conducted a scenario analysis assuming a one-third loss of shipping capacity in the Strait of Hormuz and performed simulations. The results indicated a tendency towards monetary tightening in response to energy shocks. In this calculation, if the weighted average price of crude oil and natural gas rose by 64% from the benchmark (crude oil at $130/barrel, natural gas at €83/MWh), the inflation rate would rise by 0.85 percentage points in the first year, while the economic growth rate would fall by 0.65 percentage points. In the second year, the accelerating inflation from rising energy prices would have a stronger impact than the decline in inflation due to weak demand, and the upward trend in inflation would continue. This scenario was then referred to as an "extreme assumption." Given the current energy shock context, where the Strait of Hormuz is practically blocked, it is worth watching what kind of scenario analysis the ECB will conduct. 

 
Although the aforementioned remarks by the Slovakian central bank governor and the ECB's previous scenario analysis have increased the likelihood of an interest rate hike, it is still too early to use a rate hike this year as the benchmark scenario. The key to raising interest rates lies in whether rising energy prices will have a secondary transmission effect and whether inflation expectations have changed. From this perspective, the current situation differs from the inflation shock of 2021-2023. At that time, a rapid recovery in demand after the pandemic, coupled with shortages of goods and labor, and the Russian invasion of Ukraine, caused shocks to natural gas and food supplies, driving core inflation rapidly. Currently, natural gas price increases are more moderate than then, and while the European economy is in a recovery phase, it has not yet faced a sharp expansion in demand. Furthermore, policy rates are already near the neutral level, which will also prompt the ECB to maintain a cautious stance before assessing the situation. In any case, the policy signals released by the ECB at this week's meeting are worth paying attention to.