ECB hawks run into recession risks

ECB commentary signalled substantial progress on withdrawing accommodation.
Group Research, Radhika Rao28 Oct 2022
  • Overnight, the ECB delivered a second consecutive 75bp hike, as expected
  • Cumulative hikes in this cycle are the most aggressive and fastest on record
  • Hawkish undertones were dialled back, suggesting December might witness divisions
  • Implications for forecasts: Runway for aggressive policy action is narrowing
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ECB rate decision

Decision and assessment

The European Central Bank hiked the main refi and deposit facility rate by 75bp to 2.0% and 1.5% respectively. After hawkish surprises at the last two meetings, this move was largely in the price. Cumulative increase in the past three months stands at 200bp, marking the most aggressive and fastest hike cycle since the start of the monetary union. Changes to the current Targeted Long-Term Refinancing (TLTRO) regime were also announced, with regard to the applied interest rate and repayment dates, deemed as necessary that “the framework is consistent with broader monetary policy normalisation and to reinforce the transmission of policy rates to bank lending conditions”. Concurrently, remuneration of the minimum reserves has been set at the deposit facility rate, rather than the main refi rate. 


There will likely be a few divisions in the December rate review. The ECB highlighted it has made substantial progress in normalising policy yet signaling that more increases were in the pipeline.

Data-dependency was underscored by the preferred ‘meeting to meeting’ approach. While inflation risks were viewed as biased on the upside, there was considerable emphasis on the downside risks to the economic outlook, compounded by a challenging geopolitical backdrop as well as a lingering gas crisis, besides the punitive impact of high inflation on consumption as well as production. 

Against this backdrop, markets interpreted the commentary to be less hawkish than anticipated. This is not entirely surprising after 200bp worth hikes already in the bag ahead of an impending recession. Looking ahead, another 75bp in Dec (or a small probability of 50bp in Dec plus 25bp in Feb) to 2.75% is likely, before the central bank draws a pause. Shift towards quantitative tightening will occur with a lag and will exclude purchases under the anti-fragmentation tool i.e., TPP framework. As has been evident after last two meetings where the ECB surprised on the hawkish end of the spectrum, we don’t expect the rate action to have material impact on the EUR/USD price action. What might matter more is a dovish pivot by the US FOMC, if any, which might be a bigger driver for growth and rate differentials.

Cloudy growth outlook

Just as the ECB tightens policy, growth risks continue to mount. Exogenous shocks pose the biggest risk to outlook, and its impact is beginning to show in economic data.

The IMF joined the increasing chorus that expects 2023 to be a soft year for the bloc, beyond this year’s base effects driven lift. Adding to factors raised in Eurozone: Uncertainty clouds outlook and ECB: Playing catch-up, PMIs have been in sub-50 terrain for much of 3Q22. The latest set of PMIs for the bloc confirms expectations of an impending recession.  The composite PMI fell to a lower than expected 47.1 in Oct from 48.1 in Sep, marking a nearly two-year low. Germany marked the strongest pace of correction. Industries impacted the most were likely energy-linked firms as supply concerns reigned high, with gas reserves, encouragingly above 90% now on aggregate.

Households are pushing for sharper increase in wages as real purchasing power is eroded by elevated inflation (9.9% in Sep). Tailwinds for demand in 1H of the year i.e., reopening buoyancy, service sector reopening, fiscal support and excess saving are likely to be dialled down in second half of the year. After averaging ~8.3% this year, we expect inflation to stay high at 6% next year. Concurrently, business surveys are also softening, and we expect hard data on production and manufacturing activity to catch down.  

Beyond support from the EU’s recovery fund, economic uncertainty over the horizon, geopolitical risks, tougher energy situation and tightening financial conditions will be a dampener for investment interests over the next 2-3 quarters. On the fiscal front, suspension of the budget rules in end of next year provides latitude to maintain an expansionary policy (for instance recent energy related support measures). Drawing from UK’s experience, national governments will be wary of undertaking a broad-based and aggressive stimulus package, instead preferring to provide directed assistance. Trading partners in Asia already reflect a slowdown in demand from Europe. Pulling these factors together, tighter financial conditions and building a difficult external environment for next year, we dial down our 2023 growth forecast for the Eurozone to -0.4% (vs 1% earlier) from 2.5% this year.

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Radhika Rao

Senior Economist – Eurozone, India, Indonesia

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