Cracks in financial markets exposed by speedy & aggressive rate hikes

by | Jun 2, 2023

The eurozone is seeing signs of inflation decelerating as prices dipped more than expected. The region’s preliminary May inflation reading fell to 6.1% y/y, below expectations for 6.3% y/y in a Bloomberg survey of economists. In Germany, the region’s largest economy, inflation significantly decreased from 7.6% y/y to 6.3% y/y. This marks the start of inflation not only falling due to base effects but also from declining prices for energy, food, and transportation.

According to the European Central Bank’s (ECB) May 4 meeting minutes released on Thursday, the March staff inflation forecast of 6% y/y for Q2 was judged too optimistic. The minutes cite core inflation as “worrisome” and this was reaffirmed on Thursday by ECB President Christine Lagarde, stating there is “no clear evidence” that prices have peaked. Furthermore, ECB Vice President Luis de Guindos told reporters this week that “we have to look very carefully at the evolution of core inflation” and victory over inflation has yet to be achieved. It’s clear to us from the officials’ comments and meeting minutes that inflation is still very much taking centre stage. Therefore, we reiterate our view that the ECB will deliver two more rate hikes to reach a terminal rate of 3.75%.

When central banks hike aggressively over a short period of time, they are bound to expose fragilities along the way. As financing conditions have tightened at the fastest pace in the ECB’s 25-year history, the central bank’s latest financial stability review discusses the vulnerabilities facing financial markets. The report specifically focused on real estate as house prices have cooled in a short period of time and could decline further as mortgage costs increase. While the review cautioned about the sensitivity of financial markets to slower growth and inflation, the ECB noted that banks have been decidedly resilient—even during the volatility in March—due to their strong capital and liquidity positions. Though some large banks received approval from the ECB’s supervisory arm to carry out share buybacks earlier this year, the central bank is now encouraging banks to focus on preserving their already strong capital ratios.

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