What Lies Ahead for Interest Rates as the ECB Takes a Pause?

The Monetary Policy Committee of the European Central Bank (ECB) has had quite a busy eighteen months. After years of maintaining historically low interest rates, they shifted gears due to inflationary pressures.

Even the specter of a banking crisis on the continent didn’t deter Christine Lagarde and her team from their rate-hiking path. For ten consecutive meetings from July of the previous year, they focused on combating inflation and raised interest rates each time.

However, the ECB recently decided to pause this cycle of rate hikes. So, what’s next for interest rates, and could the ECB even consider reducing rates in the near future?

Late to the Game

The current surge in inflation began in earnest around mid-2021. As global supply chains awakened following the easing of pandemic restrictions, consumer demand surged, boosted in part by savings accumulated during lockdowns.

The Bank of England became the first major central bank to raise interest rates by the end of the year, followed by the US Federal Reserve a few months later. In contrast, the ECB adopted a cautious “wait and see” approach and delayed its rate hikes compared to its counterparts.

It finally joined the rate-hiking path with a significant move in July of the previous year. While many expected a modest 0.25% rate hike, the ECB surprised by raising rates by a full 0.50%.

Christine Lagarde’s language on that day became decidedly hawkish, and forward guidance on rate hikes was abandoned. The ECB declared that rate decisions would be made on a month-to-month basis, depending on data.

The July hike was followed by an unprecedented 0.75% increase in September. Even the most dovish commentators agreed that, despite being late, these hikes were warranted.

Divergent Views

As 2023 arrived and a milder-than-expected winter defied the worst predictions of inflation pessimists, opinions on the future of interest rates began to diverge.

The “doves” argued that rate hikes should be given more time to take effect, and the ECB should adopt a “wait-and-see” approach. On the other hand, the “hawks” believed inflation needed to be decisively tamed.

The hawkish argument appeared to prevail. Even the collapse of US lender Silicon Valley Bank and warnings about potential contagion in the broader banking sector couldn’t make the ECB pause its rate-hiking cycle in March of the current year. The bank continued with a 0.50% hike.

“Inflation is projected to remain too high for too long,” Christine Lagarde emphasized, doubling down on the ECB’s mission to combat inflation.

The March rate increase was followed by a series of 0.25% hikes until the previous month. Although euro zone inflation, which peaked at 10.6% in October of the previous year, has been gradually falling, it still stands at 4.3% in September, well above the ECB’s 2% target.

‘Higher for Longer’

The phrase “higher for longer” has replaced “transitory inflation.” But just like the transitory argument, there are skeptics of the “higher for longer” view. Some analysts believe that the ECB may be forced to cut interest rates sooner rather than later, primarily due to economic weakness in member countries, especially Germany.

The general consensus is for rate cuts in the second half of the next year, with the deposit rate expected to reach 3.5% by the end of September. However, Christine Lagarde has stated that it’s too early to discuss rate cuts at this time.

Hawks on the Alert

The possibility of more rate hikes in the future cannot be ruled out at this point, as energy markets have become increasingly volatile. Gas and oil prices have fluctuated due to various factors, and this uncertainty may influence the ECB’s future decisions.

After ten successive rate hikes, mortgage holders are at least relieved that the ECB has paused its rate increases. Tracker mortgage holders, who have faced each rate hike since July of the previous year, may particularly welcome this decision.

Variable rate mortgages have remained largely stable, but some have started to increase. For those transitioning from fixed-rate periods, they may hope for lower interest rates to materialize before that happens. However, a cut at the ECB level doesn’t guarantee a corresponding decrease in retail bank rates.

While a pause in rate hikes is positive news for borrowers, it appears that the interest rate environment could remain relatively high for the foreseeable future.