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ECB interest rates 2023: 4, 6 or 8% - or it doesn't matter?

Can and will the European Central Bank (ECB) raise its key interest rates further in 2023? Which peak can be expected? Dr. Volker Schmidt, Senior Portfolio Manager, presents three scenarios.

"Even though the ECB's interest rate hikes in December turned out largely as assumed, many market participants were surprised by the statements of the ECB's Governing Council: the view that interest rates still have to rise significantly and at a steady pace has changed expectations of interest rate developments," Schmidt classifies. In December, key interest rates had risen by another 50 basis points to a total of 250 basis points. Even though the ECB has slowed down the pace, Schmidt sees no indication of an end to interest rate hikes in the near future.

Scenario 1: Key interest rate of 4%

"It is certain that the central bank is planning two more 50 basis point increases at its meetings in the first quarter of 2023. Overall, this means that a maximum value of 4% for refinancing interest rates seems likely," Schmidt explains. In his view, this is the most likely interest rate scenario for 2023, which he says is a trade-off between the need to dampen demand, anchor inflation expectations at a low level and be cautious about overshooting interest rate hikes. If one reads long-term inflation expectations from consumer surveys and the prices of inflation-indexed bonds, they remain manageable at around 3%, according to Schmidt. A decoupling of inflation expectations is currently the ECB's greatest concern, but it has hardly any influence on some factors, above all the exploding energy costs, which depend on the weather and geopolitical developments.

Scenario 2: Interest rate level of 6%

Inflation in the Eurozone is again expected to exceed 6% on average in 2023, higher than in the US. "This alone would justify an interest rate level of 6%. This would also mean that European key interest rates would be above those in the USA," explains the ETHENEA expert. "To fight inflation in the long term, central bank policy would have to become significantly more restrictive: Key interest rates would have to be higher than the inflation rate. However, the extensive government support programmes counteract the restrictive measures of the central banks."

Schmidt refers to a thesis of the well-known French economist Olivier Blanchard: The excessive support programmes of the Trump and Biden administrations ultimately caused the current inflation. Accordingly, the governments in Europe and the European Union are currently committing the same mistake and would keep inflation high or fuel it further with their planned spending. By significantly raising the key interest rates, the ECB could make the necessary borrowing more expensive and ultimately limit it. "State support as well as significant wage increases would, however, continue to ensure stable consumption," Schmidt explains. The above-average number of job vacancies will only decline when there is additional pressure on the economy. Until then, the upward trend in wages would continue. The collective agreements in Germany (for example, IG Metall, VW house collective agreement) show wage restraint for 2022 and 2023, but a significant increase in 2024.

Scenario 3: Shock therapy with high interest rates of 8%

Another option would be shock therapy in the form of raising key interest rates to 8%, similar to Hungary. "This could be justified by the dramatic increase in monetary assets in the pandemic. A shock is needed to defeat inflation. However, we rule out such a request for the ECB," Schmidt said.

He sums up: "We currently assume that the absolute level of key interest rates is less decisive. The ECB can only really influence part of the recent strong price increase. It can directly increase the cost of credit for companies, consumers and the state." However, he said, private financial assets in particular are very high, so consumers are less reliant on credit. "And the ECB has no influence on the river levels in France or the shutdown debates for power plants, on boycotts and supply or purchase restrictions from and against Russia. At best, it is currently a passenger in the inflation trend or even just sits on the back seat." The central bank is currently only doing the minimum to keep inflation expectations low and is also dependent on the actions of others.

Fighting inflation must be global

"Inflation in its current form is global and can only be fought together; each central bank must do its part, and none can do it alone," says the ETHENEA portfolio manager. The other major central banks in the US, UK, Canada and Switzerland are also continuing to raise interest rates, but at a slower pace. "It is inconceivable that inflation remains high only in the Eurozone but falls permanently below 2% in the rest of the world. It is even less conceivable for inflation to fall permanently in the eurozone but remain high in the other major economies. Either the central banks all succeed, or they don't," says Schmidt. If they do not succeed quickly, much higher interest rates could follow, both in the Eurozone and globally.