Central bank rates are likely to stay higher for longer
The current tightening cycle is already the strongest in the ECB’s history and the full impact of interest rate hikes is yet to be fully felt. Despite this, sticky services inflation and strong wage growth will likely embolden the ECB to continue its policy, with one more final 25bps interest rate increase in September.
We expect the ECB to maintain a data-dependent approach and will refrain from providing guidance on the future interest rate path. However, in our view, most policymakers consider the costs of protecting the economy from upside risks to be much lower than the costs of reacting only after upside risks to inflation have materialized. Therefore, a rapid decline in headline and core inflation indicators may not be sufficient stimulus for a policy rate cut in Q1 2024. In particular, if nominal wage growth remains high and is not sufficiently absorbed by firms in their profit margins, the ECB may hold rates steady even until June 2024. Therefore, in our baseline, monetary policy in the euro area is overtightened and businesses should be prepared for a “higher for longer” scenario.
With headline inflation cooling to 7.9% in June and core inflation moderating slightly to 6.9%, the BoE is likely to favor a 25bps rate hike in July after a 50bps rate increase in June. With forward-looking indicators suggesting inflation will fall further in the second half of 2023, and the labor market now decisively cooling, we expect one more final 25bp hike, to 5.5%, and a first rate cut in Q2 2024. This makes our BoE monetary policy forecasts more dovish than implied by market expectations.
With the ECB tightening policy further and core inflation remaining above the target, we expect the central banks of Switzerland, Sweden and Norway each to raise rates twice more and we do not anticipate rate cuts in these countries before the second half of 2024. In contrast to advanced economies, CEE central banks ended the hiking cycle many months ago and have either already begun the easing cycle (Hungary, though from a very high level of 18%) or are expected to start cutting rates in Q4 2023 (Czechia and Poland), despite inflation remaining close to 10%. Given its continuing heightened inflation, we anticipate the easing cycle to be gradual in Poland. By contrast, the Czech central bank is likely to cut interest rates much faster next year as inflation quickly approaches the 2% target.
While we consider both upside and downside scenarios for the inflation outlook and monetary policy path, in either case the era of “low for long” interest rates is over and business models should account for a higher cost of capital compared with the pre-pandemic period.
On one hand, private indebtedness is historically high in Europe, which can greatly heighten the sensitivity of the private sector to higher interest rates. The effects of monetary policy tightening have already become apparent in the overall negative loan growth in the euro area. On the other hand, the pass-through from higher interest rates to debt service burdens has been delayed, as companies lengthened maturities of their debt during the period of low inflation. In addition, in many countries, more people have moved to longer-term fixed-rate mortgage contracts, which reduces the direct effect of interest rate changes on homeowners’ mortgage costs. However, a growing proportion of owners and companies have already or will soon need to refinance at much higher interest rates.
The balance of risks continues to lean to the downside
High nominal wage growth, if not absorbed by firms’ profit margins, poses a risk for a more prolonged cost-push inflation dynamic and more persistent inflation in services. This would put additional upward pressure on interest rates, leading to tightening of credit and financial conditions which could precipitate non-linear private sector responses with pullbacks in consumer spending and business investment.
Excessive monetary policy tightening can lead to a resumption of banking sector stress, commercial real estate fragilities and other unknown unknowns that could trigger severe funding pressures on businesses, drive further bank failures and put significant strain on the availability and cost of credit. However, as we argued in our April Outlook, the risk of bank failures in Europe is limited and the position of European banks remains strong.
Geopolitical tensions, including the war in Ukraine, continue to be a key risk and if they intensify, could lead to more energy and food price spikes. Potential harsh weather conditions could exacerbate imbalances in energy markets, particularly ahead of the 2023-24 winter.
The good news is that post-winter natural gas storage levels in Europe are historically high, which has significantly reduced the short-term energy security risk. Despite this, energy costs in Europe remain higher than in the US and many other countries. In addition, in the short to medium term, Europe will remain more vulnerable to potentially more frequent negative supply-side shocks originating in the energy market. On one hand, we will see an increasing share of renewables in the energy mix that should help strengthen Europe’s energy security over time. On the other hand, these intermittent renewable energy sources, due to their fluctuating nature, can make energy supply in Europe more unpredictable. This in turn could trigger large price movements in energy markets that businesses should be prepared for and include in their scenario planning to navigate uncertainty.
While in our baseline we forecast a decline in food price inflation as the effects of previous food and energy commodity price shocks fade and partially revert, there are significant upside risks to this scenario. These include extreme weather conditions in many countries (e.g., very high temperatures in Southern Europe and arrival of the El Niño weather pattern) and policy decisions such as Russia quitting the Black Sea Grain deal and India, as a top rice exporter, banning some shipments of the commodity to reduce domestic price pressures.
Our analysis shows that Europe is more vulnerable to a renewed increase in commodity prices than other major economies, in particular the US. In the event of another spike in energy costs and food prices, CEE countries would be most adversely affected in terms of both GDP and inflation, with the greatest impact on GDP for Czechia, Hungary and Romania and the strongest increase in inflation in Poland, Hungary and Slovakia. Southern and Nordic countries would be affected less, though still more than major non-European economies such as the US or Japan.
Elevated debt levels increase vulnerability to financial market turbulence, especially among emerging markets and developing economies. They also limit the fiscal space to offset new negative shocks and their impact on households and businesses.
An upside risk to the outlook stems from a faster disinflationary cycle and a more rapid supply and productivity rebound supported by a faster labor market rebalancing, easing wage pressures and less cost passthrough. In such a scenario, lower inflation would lead to a lower interest rate path, thereby supporting stronger growth.
Moreover, structural labor market tightness and labor shortages should incentivize firms to invest more in productivity-enhancing and labor-saving technology, including exploiting the economic potential of generative AI. This potential to boost productivity seems to be relatively large in Europe, as European firms lag the US in R&D investment and the adoption of digital technologies.
