Therefore, central bank rates may stay higher for longer
It is worth mentioning that the current tightening cycle is already the strongest in ECB history and the Fed has not been this hawkish for over 40 years.
The ECB will maintain a data-dependent approach and, due to increased uncertainty over the effects of the recent turmoil in the financial sector regarding credit conditions, will refrain from providing guidance on the future interest rate path.
However, given that core inflation in the euro area has recently hit another record and labor markets remain very strong, in our view, for most ECB policymakers further rate hikes will be warranted. We expect the ECB deposit rate to be raised by another 75bps to 3.75%.
Following the latest rate increase (by 25bps to the 4.75-5% range), the Fed has turned significantly more dovish as a result of the turmoil in the US banking sector. Another 25bps hike in May 2023 seems likely and we also expect the Bank of England to raise its base rate once more, reaching a peak of 4.50%.
The 2023 economic outlook has improved, but the balance of risks leans to the downside
Persistent elevated inflation would squeeze household budgets for longer and impact private consumption, in addition to increasing the risk of excessive monetary policy tightening by major central banks that may prefer to err on the side of caution.
The recent turmoil in the banking system, beginning with the failures of some US banks, is a new cause for concern. However, given different financial supervision rules covering much smaller banks in Europe, the same situation is unlikely to occur. The most recent assessment conducted by the European Banking Authority confirms the strong position of European banks.
Even prior to these developments, banks had already tightened credit standards, due to rising interest rates. The effects of monetary policy tightening have become apparent in the overall negative loan growth in the euro area for the first time since 2014, and a slowdown in new home construction in many countries. The full impact of interest rate hikes is yet to be felt fully. The latest events may make banks even more reticent in lending, which could weigh further on economic growth, although we do not know how significant or lasting this will be. Central banks, especially the ECB, will now be watching lending conditions more closely, which may reduce the scale of increased interest rates required. Pockets of vulnerability exist in the banking sector, but also may apply to non-bank financial institutions, which continue to play a growing role in global markets.
In our baseline scenario, the banking turmoil will be contained, without significant impact on the European economy. However, volatility in market sentiment could continue, together with hunting for weakness, and more rigid lending standards increase the risk of overtightening by the ECB, which may later need to recalibrate its monetary policy.
In an alternative scenario, in which we assumed that the current turmoil leads to an additional tightening of credit conditions (a third as large as those during the global financial crisis), by 2025 GDP in the euro area would be almost 2% lower than in the baseline.