There is renewed anxiety among central bankers in the face of sticky inflation.
Despite widespread pessimism on prospects for major economies, growth has remained resilient. That is the good news; the downside is that inflation has also remained strong in spite of tightening monetary settings. Private sector balance sheets remain healthy. Tight labor markets on both sides of the Atlantic are fueling wage gains and underpinning spending.
Aspirations for a soft landing had tempered the pace of monetary policy tightening. But there is renewed anxiety among central bankers in the face of sticky price pressures. Monetary authorities have either resumed tightening or turned more hawkish, displaying their willingness to take conditions further into restrictive territory. The cost of overtightening to prevent a wage-price spiral is seen as small relative to the cost of underestimating inflation’s persistence.
We continue to expect soft landings in the major centers, but uncertainty around the drag from tighter financial conditions increases the downside risk.
This month’s edition of the global outlook offers a deep dive into the eurozone economy.
- The European Central Bank (ECB) has responded to the surge in inflation by embarking on the fastest tightening cycle in its history. Although core inflation decelerated last month, one data point doesn’t make a trend, and underlying price pressures are still elevated. This justifies a hawkish tone from the ECB. Officials signaled that more tightening will likely be required amid strong labor market and wage dynamics. A hike in September, which seemed highly unlikely prior to this month’s meeting, is now a real possibility.
- We now expect the ECB to hike by 25 basis points at its next two meetings in July and September, taking the peak deposit rate to 4.00%. The risk of overtightening is present, as the impact from past increases in interest rates has yet to fully feed through to the real economy. This is perhaps the only factor that could force the ECB to pause the current cycle next month.
- With Europe's gas crisis diminished and budget rules set to become binding again in 2024, fiscal policy will soon become a drag on growth. However, some European governments remain under pressure to provide support to cap rising prices and protect purchasing power. But there is limited scope for further assistance, given rising government interest payments.
- Europe will also have to find room in national budgets to address climate change, defense, and technology transition. Debate is active on how these investments will count against debt and deficit targets.
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