Markets overestimate how far the ECB can hike, despite hot CPI
September’s inflation print strengthens the case for a further ECB hike, but we think markets are overestimating how far rates can ultimately rise.
Headline inflation accelerated to 3.8% YoY in September, above the 3.7% consensus, but the composition still points primarily to an energy shock rather than a broad-based uptick in price pressures. With growth facing renewed headwinds and French sovereign stress tightening financial conditions independently, we remain sceptical that the ECB can sustain the deposit rate materially above 3%.
Admittedly, we do think that September’s headline reading keeps pressure on the Governing Council to act again.
But core inflation at 2.5% suggests that second-round effects remain relatively contained, even as services inflation warrants monitoring. Absent evidence that higher energy costs are feeding into wider inflationary pressures, we see little justification for the ECB to aggressively tighten monetary policy, having already hiked by 50bps over recent months.
Indeed, the ECB raised the deposit rate by 25bps to 2.50% in September, though without committing to a predefined path.
Its latest projections see headline inflation averaging 3.0% this year and core inflation at 2.5%, albeit these forecasts were compiled before the latest rise in energy prices. Against this backdrop, markets have continued to build in further tightening, reflecting the worsening inflation outlook. But at the same time, French 10-year yields have moved close to 5%, while the spread over German Bunds has widened to levels last seen during the eurozone debt crisis. While the ECB has stressed that its mandate is price stability rather than managing individual sovereign spreads, tighter financial conditions nevertheless increase the economic cost of additional rate hikes.
We therefore retain our call for further ECB tightening, with a December move more likely than October, but struggle to see a prolonged tightening cycle from here.
Growth headwinds and tighter fiscal conditions both warrant caution, and should weigh on inflationary pressures in any case. For the euro, additional ECB tightening is not automatically positive if it simultaneously damages growth and amplifies sovereign stress. The limited euro response to the latest inflation surprise shows markets are beginning to recognise that trade-off..