March’s Eurozone consumer price index (CPI) was again higher than expected. Headline inflation jumped from 5.9% to a new record high of 7.5% - as the first chart shows - owing to surging oil and gas prices caused by Russia’s invasion of Ukraine. In addition, core inflation, excluding energy and food costs, rose from 2.7% to 3.0%.
Source: Bank of Singapore, Bloomberg.
Financial markets now expect the European Central Bank (ECB) will start raising its -0.50% deposit rate from the summer and undertake quarterly 25bps rate increases to reach 0.50% in 12 months’ time.
But we expect the ECB will likely take longer to start increasing interest rates, keeping us cautious on the EUR over the next few months.
Source: Bank of Singapore, Bloomberg.
First, the ECB is still printing money to support the recovery from the pandemic and may not finish quantitative easing (QE) until September. The ECB could announce at its April or June meetings that it will end QE earlier given inflation has surged above its 2% target. But the ECB’s forward guidance notes interest rate hikes will only start ‘some time after’ its bond buying ends.
Second, the ECB is likely to be wary of the near-term risks to growth from the war in Ukraine.
The central bank’s forecast of a 3.7% expansion in Eurozone GDP this year appears too high. We forecast a 3.2% rise. Moreover, should Russia’s exports of oil and gas to the European Union be disrupted because of the fighting or EU countries impose even stricter sanctions in response to atrocities in Ukraine and restrict or ban Russian energy supplies as the US and UK have done, then the Eurozone will face a much higher risk of recession in 2022. The second chart shows indicators of business and consumer sentiment including Germany’s IFO survey and the European Commission’s economic confidence data have fallen sharply in March.
Thus, we think the ECB will remain cautious about tightening despite inflation being far above its 2% target. We expect its first hike may not occur until December while the Federal Reserve, in contrast, keeps hiking rates at each meeting this year. We therefore see the EUR falling into a lower 1.05-1.10 range against the USD over the next few months.
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