ECB Preview: Stagflation fears drive rate hike uncertainty

The ECB reconvenes for their latest monetary policy meeting on Thursday, with markets more uncertain than ever over whether the tightening phase will continue after a historic tightening phase that drove price up from -0.5% to 3.75% in just over a year. Coming in the wake of nine consecutive interest rate hikes, there is a feeling that we are fast approaching the so-called ‘terminal rate’ at which the bank will hold rates steady and hope they continue to work their magic on inflation.

Stagflation it the word on the mouths of economists in Europe, with a weakening growth outlook coming amid elevated and sticky inflation rates. Will the central banks continue to target inflation or fold under the pressure of being responsible for an economic crisis and job losses?

What does recent data tell us?

Part of the rhetoric around a potential halt to the ongoing tightening phase has come in response to a weakening of eurozone data, with a fall in services PMI surveys signalling contraction across both sides of the economy. Manufacturing has long been under pressure according to this metric, with the critical German industry seeing particular losses according to the worrying 39.1 figure confirmed for August. The fact that we are now seeing then services sector fall into contraction will be a concern over a potential recessionary environment building, but also encourages the notion that we will see price pressures cool in a segment of the economy that has been a notable source of inflation.

Inflation remains the key determinant of monetary policy, with central banks only willing to take their foot off the gas in the event that inflation signals the potential for a move back towards target. The ability to gauge whether that is likely can be tough given the raft of inflation metrics and the role base effects can have on the annual rate that everyone closely follows. With that in mind, it is worthwhile keeping an eye on the short-term price movements as a gauge over whether monetary policy is finally kicking in to drive down CPI growth. With that in mind, the latest figure of 0.6% for August will be a concern for the ECB. However, the volatility we have seen across the monthly inflation gauge highlights the need to smooth it out. With that in mind, the past three-months have seen CPI rise 0.8%, which annualizes to 3.6%. Above target, but things are clearly moving in the right direction despite monthly volatility.

Core inflation remains equally important for central banks, with monetary policy less likely to have an impact on the volatility commodity-driven elements stripped out by the core metric. Interestingly, we have seen the core figure converge with the headline number, with both metrics currently well above target at 5.3%. The trajectory has only recently turned downward, and the pedestrian pace of that turnaround will not fill many with confidence that we are going to reach 2% anytime soon.

Markets expect another hike

With the economic outlook taking a turn for the worse and disinflation moving at a snails pace, there will be plenty of disagreement at the forthcoming meeting. The fact that markets (and the ECB) are undecided over the outcome of this meeting should bring volatility for the euro. If we look at the market pricing around where the terminal rate will be, it signals an expectation that we will see one more final hike before Lagarde & co enter the holding phase. The upward trajectory seen over the course of the past year highlights how markets have constantly had to adjust to a new ‘higher-for-longer’ approach thanks to stubbornly high inflation. That puzzle is yet to be solved, but things are moving in the right direction.

Where now for the euro?

Looking at the EURUSD pair, we have a clear downtrend playing out over the course of the past two-months. This is certainly driven in part by risk aversion, as equity markets come under pressure. In terms of price action, the declines have taken us into a support zone that could herald a wider breakdown if broken. With that in mind, the 1.0635 level will become increasingly important if we see the pair under pressure. For now, another rate hike and a pledge to hike more if the data requires would likely push EURUSD higher. However, a move up through 1.09454 would be required to signal the end of this bearish phase. Until then, short-term gains look likely to be sold into. To the downside, a decision to pause rates and hold off on any tightening could drive further downside from here, with a break below last weeks low of 1.06858 would point towards a challenge of the key 1.0635 May low.