The head of Belgium's central bank, Pierre Wunsch, does not rule out interest rate hikes by the European Central Bank (ECB) if expectations on the financial markets do not meet the ECB's wishes. In an interview, the member of the ECB's Governing Council said that the central bank could be forced to raise interest rates again if investors' bets on the financial markets undermined the direction of monetary policy.
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It's a problem if everyone thinks interest rates are going to go down, Wunsch said. Eventually, yields on the capital markets fall. "Then we will have a less restrictive monetary policy," Wunsch said. "And I'm not sure it's going to be restrictive enough." This increases the risk that the direction will have to be corrected.
This announcement to the participants in the financial markets means in clear German: If you expect interest rates to fall, then we will raise them. Paradoxically, if you continue to bet on interest rate cuts on our part, it will lead to a rate hike. This is now the third argument with which the central bank wants to combat the expectation of interest rate cuts for the coming year.
The ECB is not in an easy situation. At its October meeting, the ECB Governing Council left key interest rates unchanged. Behind this was the hope that the interest rate level would be sufficient to drive inflation towards the ECB's target of 2 percent. The ECB can control short-term interest rates quite well via key interest rates. The situation is somewhat more complicated with longer-term capital market interest rates. The fact that many investors in the financial markets expect interest rate cuts in 2024 is a problem for her, as can be seen from various financial market curves (see chart).
However, the expectation of falling interest rates in the future may already hinder the fight against inflation. That is why the ECB is trying to talk the financial markets out of this expectation.
Last mile of fighting inflation will be tough
The first argument was: uncertainty. The further development of inflation was highly uncertain, it had been said. The central bank can therefore only proceed "data-dependently" with its interest rate policy, ECB President Christine Lagarde had said. She dismissed speculation about interest rate cuts as "completely premature". In addition, Bundesbank President Joachim Nagel, representing the "hawks" on the ECB Governing Council, i.e. the advocates of tighter monetary policy, had repeatedly emphasised that further interest rate hikes should not be ruled out. All of this should dampen expectations of interest rate cuts.
The second argument was: Be careful, the base effects can be reversed! In a keynote speech in the United States just over two weeks ago, ECB Executive Board member Isabel Schnabel argued that the "last mile" in fighting inflation could still be tough, much like a long-distance run. It may still take some effort to bring inflation in the euro area from 2.9 percent to the target of 2 percent. Most recently, the central bank has benefited from statistical base effects, for example in energy. Because energy was so expensive last year, the normalization of energy prices this year had a downward impact on the year-on-year inflation rate. Such base effects, however, go like a pendulum sometimes in one direction, sometimes in the other, Schnabel warned: next year they could drive inflation again. Again, the message was clear. Dear financial markets, don't speculate so much about interest rate cuts, it can turn out quite differently.
So now the third argument: It is not only external circumstances and reversing base effects that could argue against interest rate cuts. It may even be the case that the bets on rate cuts themselves will be the ones that make further rate hikes necessary.
We might know more in January
"After all, the market is already pricing in very significant interest rate cuts," said Marco Wagner, ECB observer at Commerzbank. "A full interest rate hike is not priced in until June 2024, but even before that – from March onwards – there are significant expectations of cuts with a probability of around 30 percent," said Ralf Umlauf, analyst at Landesbank Hessen-Thüringen.
Interest rate expectations on the financial markets could fall even further if the inflation figures are published next week, according to Commerzbank. It expects an inflation rate for the euro area of 2.7 percent in November. This could then look even more like a victory over inflation. But as early as December, the euro inflation rate could be well above 3 percent again. The inflation figures for October to December in particular are influenced by volatile prices for energy and food and special effects. It will not be until January that we will see a little more clearly.
"The expectation of falling policy rates leads to a less restrictive monetary policy environment as interest rates on long-term financing fall," says Karsten Junius, economist at Bank J. Safra Sarasin. "We have seen this effect in recent weeks, when the risk of further rate cuts has been priced out and the first rate cuts have been priced in."
The yield on the German government bond fell, building interest rates fell somewhat, and some banks even lowered their interest rates on fixed-term deposits to one year. "This runs counter to the current monetary policy," says Junius: "It is therefore consistent when Mr. Wunsch expresses that the ECB may have to compensate for the expansionary effect of financial market movements with a more restrictive course."