The ECB will choose inflation over the economy at this week’s monetary policy meeting

Thursday's ECB rate hike is taken for granted. However, the market is starting to doubt that the central bank will be able to hike rates again in the fall.

Data indicates we are going towards a recession. Monday’s German manufacturing PMI dropped to 2008 lows. Today’s ECB’s Bank Lending Survey showed that credit standards tightened further and that demand for loans decreased sharply in the second quarter of 2023.

Yet, inflation remains a problem with the Eurozone headline and core CPI at 5.5%. Not only, but on Friday, economists expect the German monthly CPI to show a 0.3% pick up in prices in July, which, if annualized, returns a figure almost double the central bank's target.

The question is whether the Governing Council will feel confident to continue to hike rates after this week’s meeting, bringing the peak terminal rate to 4%.

Hence, we see three possible scenarios playing out:

1. Neutral meeting: 25bps rate hike, balance sheet policies unchanged. Indications of another data-dependent rate hike if needed.
2. Hawkish meeting: 25bps rate hike, balance sheet policies unchanged. Lagarde focuses on wages, indicating that at least one more rate hike is warranted to fight inflation.
3. Dovish meeting: 25bps rate hike, balance sheet policies unchanged. Lagarde signals that this might be the last rate hike and that inflation will continue to fall as economic activity slows.

The market widely expects the ECB to remain neutral and data-dependent (option 1). However, there is a chance that ECB will stick its guns with a hawkish message (option 2).

The reason for that lies within the medium-term symmetrical inflation target concept introduced by the ECB in 2021. According to such a framework, inflation is equally undesirable when it rises above or drops below the 2% target. With "medium term," the central bank refers to the fact that it will not focus on short-run inflation dynamics, in which deviations are inevitable.

Although the ECB inflation target has been raised within the new framework (before, the inflation target was "below, but close to, 2%”), adopting such a strategy was essentially a dovish move. Indeed, it is changing how the central bank looks at the effective lower bound rate -the concept that policy rates cannot drift too far into negative territory while there is no cap regarding how high the ECB can raise them. In short, the ECB has assured that in a recession, where recovery is slow, it can forcefully cut rates and prolong accommodative monetary policies to avoid persistently low inflation, as we have experienced in the past ten years.

The above leads us to think that the ECB might prefer to hike now and cut aggressively later because they need to solve a problem first before jumping onto the other. Hence, unless the economy is in a dire state, a peak ECB terminal rate of 4% remains in the cards, and the ECB will prefer to stick to its hawkish stance rather than show its dovish fears.