In Brief

• At its monetary policy meeting on 4th May, the European Central Bank (ECB) tighten monetary policy further, increasing key interest rates by 25 basis points (bps).
  
  
• The accompanying statement was hawkish, with the ECB stated that “the inflation outlook has been too high for too long”, while President Christine Lagarde confirmed “we are not pausing” and “we have more ground to cover”.
  


• The ECB also announced its intention to stop reinvesting maturities proceeds from the asset purchase programme (APP) from 1 July 2023.

Decelerating rate hikes

At its 4th of May monetary policy meeting, the ECB increased all three key interest rates by 25bps, bringing the refinancing rate to 3.75%, the marginal lending facility to 4.00% and the deposit facility rate to 3.25%. The increases were in-line with market expectations and represent the seventh hike in the current cycle, taking cumulative rate hikes to 375bps since July 2022.

The 25bps hike also signifies a slower pace of hikes, with the absence of a further acceleration in April’s inflation reading, alongside signs that credit conditions have tightened and loan demand declined in the recent ECB Bank Lending Survey, enough to persuade the central bank that a smaller move was appropriate.

Figure 1: ECB deposit rate has reached a 15-year high of 3.25%.

Source: Bloomberg, as at 5 May 2023.

Nevertheless, the ECB still believes the inflation fight has not yet been won. At the subsequent press conference President Lagarde noted that the inflation outlook continued to be “too high, for too long”, and, although headline inflation has started to recede, “underlying price pressures remain strong”.

President Lagarde kept open the option of further hikes by stating that “future decisions will ensure that the policy rates will be brought to levels sufficiently restrictive to achieve a timely return of inflation to the 2% medium-term target”.

Accelerating quantitative tightening

The GC also announced an earlier than expected decision to stop reinvesting the maturities of its APP portfolio from 1 July 2023. The portfolio is currently declining at a pace of EUR15 billion per month, which will increase to approximately EUR 25 billion from July. This increase represents an additional tightening of market liquidity. Notably, the pandemic emergency purchase programme (PEPP) holdings, will continue to be reinvested until at least the end of 2024.

Confirming confidence in the banking system

Cognizant of current global banking concerns, the ECB confirmed the European banking system was “strong” and “resilient”. At this juncture it seems unconcerned about next month’s expiry of EUR 477 billion worth of TLTROS (targeted longer-term refinancing operations) and does not appear to be planning replacement bridging loans. President Lagarde observed that commercial banks could request funding via the ECB’s refinancing operations, should the need for replacement financing arise.

Data dependent

President Lagarde confirmed that ECB decisions remain data dependent, and notably, called for governments to roll back fiscal stimulus now that the energy crisis has faded, to avoid upward pressure on inflation and the resultant additional tightening of monetary policy.

Eurozone economic data remains modestly positive with advanced GDP indicating the eurozone economy grew by 0.1% in the first quarter, helped by lower energy costs, easing of supply bottle necks and fiscal policy support for firms and households. Although the manufacturing sector remains weak, the services sector is growing faster, supported by improving consumer confidence and higher household spending as a result of record low unemployment.

Meanwhile, headline inflation rose marginally to 7%y/y in April but remains significantly below its fourth quarter peak of 10.6%y/y. However, core inflation has proved sticky at 5.6%y/y, due to persistently high food prices and higher services inflation.

Figure 2: Eurozone unemployment remains low while wage growth has accelerated.

Source: ECB, Eurostat, Refinitive Datastream, J.P. Morgan Asset Management, as at 31 March 2023. Wage growth is based on negotiated wages.

Figure 3: Headline inflation is falling but less volatile core inflation continues to rise

Source: Eurostat, European Central Bank, Bloomberg, as at 5 May 2023.

Implications for euro cash investors

The latest rate increase is good news for cash investors. J.P. Morgan Asset Management’s liquidity funds are well positioned to benefit from higher rates, given the high levels of short-dated cash they carry. Deposit and repo rates should refix higher at the start of the new reserve period on 10 May, providing an almost immediate boost to the fund’s yield. Higher reinvestment yields for term securities will also benefit the fund over the coming weeks.

Conclusion

The May ECB meeting contained few surprises but in opting for a slower pace of hikes, the ECB acknowledged that a lot of the monetary policy heavy lifting has already been done and that the full impacts of previous rate hikes are still feeding through. Nevertheless, highlighting upside risks to inflation, the ECB clearly thinks that further rate increases will be necessary, although the peak level of rates will be data dependent and is far from certain. Against this backdrop, markets are likely to remain volatile and we believe investors will be well served by our active approach to cash management, prioritising diversification and liquidity.

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