ECB Policy Rates Not Peaking Yet

While the ECB raised its deposit facility rate by 25 basis points (bps) to 3.5% at the June meeting, we believe the risks remain skewed towards higher policy rates for longer compared to market expectations. The ECB refrained from communicating unconditional expectations for the future interest rate path, but made clear that it expects to raise rates further, including at its next policy meeting in July. It is aiming to bring policy rates to levels sufficiently restrictive to achieve a timely return of inflation to the 2% price stability target.

We continue to believe that a 4% terminal ECB policy rate looks reasonable, though we see some upside risk to this estimate as labour markets have been surprisingly resilient and inflation is likely to remain sticky. We also note the peak rate of 3.9% expected for the deposit facility remains around 30 bps below levels priced in before the failure of Silicon Valley Bank in March (according to the OIS (overnight index swap) forward curve). We think the bank-related financial turmoil is unlikely to fundamentally change the ECB’s inflation outlook. We regard 3.75% as the lower end of the terminal rate landing zone for the deposit facility.

Preliminary inflation estimates for the euro area surprised to the downside in May, but underlying price pressures remain firm and the inflation outlook continues to be “too high for too long.” Indeed, euro area headline inflation for May is expected to settle at 6.1% year-over-year (YoY), suggesting the ECB cannot conclude its work is done just yet. Upside risks, especially in terms of the duration of the inflation-adjustment process, arise from still-strong domestic and wage-intensive components of inflation.