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By Roxane Spitznagel, economist, Investment Strategy Group, Vanguard Europe
Eight years of negative interest rates in the euro area will likely end in September as the European Central Bank (ECB) hikes rates to fight inflation. Vanguard believes Europe will escape a recession in 2022, unless it experiences a halt in the inflow of Russian natural gas. Our view is that the ECB will tighten policy at a faster pace than current market expectations.
The ECB’s meeting on 9 June was just the latest in a series of overt signals that its monetary policy will be more hawkish than before because of inflationary pressures.
The central bank announced it would end its Asset Purchase Program on 1 July and intends to increase the ECB deposit rate by 25 basis points (bps) in July and September. It left the door open for a larger rate hike in September.
Additionally, in an emergency meeting on 15 June the ECB pledged to accelerate work on a new instrument to tackle borrowing costs in weaker euro area economies should it be needed.
Our base case scenario is a 50 bps hike in September. This would bring rates out of negative territory by the third quarter. We expect a total of 100 to 125 basis points of tightening in 2022—considerably higher than our earlier forecast of 50 bps. We think a ‘gradual’ climb in rates as the ECB described it will be challenged given the hot inflation outlook. For 2023, we believe inflation will be higher than the ECB’s forecast and the bank will raise rates at a faster rate than current market expectations.
A key reason for the ECB’s pivot towards a more hawkish stance, and the sharper turn in Vanguard’s forecasts: inflation is rapidly spreading throughout the economy, beyond the volatile food and energy components that are directly impacted by Russia’s invasion of Ukraine.
Three months ago, 40% of the basket of goods and services witnessed inflation rates that were 2 percentage points above the historical average. It’s now 60% of the basket.
Services inflation has accelerated to its highest point since the euro’s introduction in 1999. That’s the more persistent part of inflation. Once that increases, the harder it is to bring inflation back down.
There’s also the danger of a wage-price spiral: higher prices push up the demand for higher wages, and firms in turn protect their margins by passing on the higher labor costs to consumers through higher prices. Wages are already rising in Europe, though at a more muted pace than in the US.
And then there are other inflationary pressures—a weaker euro and larger-than-expected supply bottlenecks stemming from China’s dynamic zero-Covid strategy. All of this has led us to upgrade our inflation forecast for calendar 2022 from an average in the range of 6.5%–7% to 7.5%–8%. We expect inflation in Europe to reach a peak of close to 9% in the third quarter of this year.
Vanguard’s inflation forecast for Europe before and after Ukraine invasion
Source: Vanguard calculations, using Bloomberg data as at 7 June, 2022.
Similar to the US Federal Reserve and most central banks today, the ECB is in a challenging position. Surging inflation warrants more aggressive tightening. On the other hand, the economy is materially weakening, which warrants a more moderate approach.
But like the Fed and the Bank of England, the ECB has been signaling in recent weeks that it considers inflation the more vital concern and that it’s willing to take stronger steps to rein it in (for more details on the balancing act that all central banks face, see Central banks have a short runway for a soft landing).
For 2023, Vanguard expects both the Fed and the ECB to raise policy rates above the neutral rate—the theoretical interest rate that will neither expand nor contract the economy—to keep inflation in check. Vanguard estimates the neutral rate to be 1.5%–2% for Europe and 2.5%–3% for the US. Our view is the ECB will raise rates to 2.5% by the end of 2023. This is about 30 bps higher than current market pricing.
An economic slowdown in Europe is likely in 2022, but not a recession, according to proprietary Vanguard indicators.
Vanguard’s leading economic indicators plummeted in 2022 but remain in positive territory
Sources: Vanguard analysis, using data from Bloomberg and Macrobond, as at 7 June, 2022.
Our forecast for full-year 2022 GDP growth in the euro area remains in the 2.5%–3% range, lower than our forecast of around 3.5% before the war in Ukraine. That is consistent with the ECB’s forecast of 2.8%, which was revised down on 9 June from its earlier forecast of 3.7%. Notes: The Vanguard Leading Economic Indicator (VLEI) is a quarterly aggregate of multiple economic variables including credit conditions, consumer sentiment surveys, manufacturing surveys and the euro’s value. Focused VLEI is a subset of variables in the VLEI. The number represents projected year-over-year GDP growth for the euro area. A negative number indicates a higher probability of a recession within the next two quarters.
Market fragmentation risk complicates matters for European policymakers. The ECB has to manage monetary policy for 19 different member states. Each of those countries has a different economy, a different bond market, a different structure, and that adds to the complication. If the ECB raises interests too fast, that has implications for financing costs for more vulnerable countries such as Italy.
An even greater risk to the euro area could come from disruptions in its natural gas supply. Because Europe is heavily dependent on Russian gas—far more so than the UK or the US—a sudden end to imports could tip it into a recession.
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