One of the most interesting central bank meetings of 2022 is the European Central Bank (ECB) meeting scheduled for next week, Thursday. The ECB plans to keep the main refinancing rate at zero, basically unchanged for many years.
But inflation is much higher than the ECB’s target. The latest CPI report showed that inflation reached 8.1% year-on-year in May, but the interest rate is zero. In addition, the deposit facility rate is in negative territory.
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Is this the biggest disconnect in history between monetary policy and inflation? Maybe it is.
The ECB, however, had difficulty defining monetary policy. First, global supply chain pressures remain high, although COVID-19 restrictions have disappeared in Europe and the developed world.
Second, the war in Ukraine, which began when Russia invaded its neighboring country in late February, led to rising prices for goods and services. But as the war negatively affected the economic recovery following the COVID-19 clash, the ECB is hesitant to normalize politics.
Will the ECB raise interest rates next Thursday? The market believes it will not, but this market cycle is so different at such levels that no results can be ruled out.
However, even if the ECB does not raise rates, the common currency, the euro, remains fundamentally bullish, regardless of what the ECB does on Thursday. So here are the two scenarios for Thursday’s result, both of which lead to a falcon result for the euro.
The ECB does not raise interest rates in June
We assume that the ECB will not raise interest rates on Thursday. While favorable to the euro, the comments accompanying the decision are likely to indicate a 50 bp rate hike in July.
Therefore, it could be a blatant decision for the euro, even if the ECB does not act on rates.
The ECB raises interest rates in June
While the vast majority of market participants will rule out a rate hike next Thursday, it must not be forgotten that the ECB is facing a historic decision. Never in the relatively short history of the common currency has inflation been as high as it is now.
Delaying the rate hike by the central bank by as little as six weeks could be detrimental to consumer confidence and ultimately to its credibility.
Other central banks have already raised rates several times. So why would the ECB be the last child in the city to do so?
In addition, a surprise rise would put the euro back on track. But why would the ECB want to do that?
The answer lies in the state of the common currency. Suppose the euro continues to fall, as it did, and inflation continues to rise.
In this case, the common currency will start to look like an emerging currency, which the ECB wants to avoid, as the euro is the world’s second largest reserve currency after the US dollar.
Raising exchange rates would increase the exchange rates of the euro.
The credibility of the ECB is at stake
It is worth talking more about the credibility of the ECB. This is the first real inflation test since the eurozone members adopted the common currency.
Credibility is key for central banks to be willing to be taken seriously by the population. This is an opportunity for the ECB to take control of the inflation narrative, even at the risk of surprising financial markets.
So a rate hike and even more splattered rhetoric should come as no surprise in June.
Will the ECB do that? Regardless of whether the rate rises or not, the euro is in a good position for a brief push.
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