The European Central Bank Out-Hawked the US Fed

Unwavering ECB

The European Central Bank (ECB) was late to start tightening its monetary policy, but has done so pretty aggressively since the July lift-off, with two to back-to-back jumbo 75 basis points rate hikes in September and October.

Given this huge rate adjustment and the economic slowdown, the central bank chose to moderate the pace of tightening on Thursday, delivering a smaller 0.5% increase. The Deposit Facility Rate now stands at 2.00% and new fourteen-year highs.

Despite this downshift, the ECB delivered an uber-hawkish message and pointed to further rate hikes, expecting them to rise "significantly at a steady pace", in order to reach "sufficiently restrictive" level that will ensure the return of inflation to the 2% target. ^[1]

Once again, the central bank refrained from defining the terminal rate, but we now have a clearer picture in regards to the next moves. Asked around their size during her press conference, President Lagarde succinctly stated that official are looking to "raise interest rates at a 50-basis-point pace for a period of time". ^[2]

We cannot now what the bank will eventually do, but the wording of the policy statement and the clarification by Ms Lagarde, points to at least two half-percentage point adjustments, meaning potentially another 100 basis worth of rate hikes.

Hawkish Fed

A day earlier, the US Federal Reserve had kicked-off this week's central bank bonanza, also raising rates by 0.5% and climbing down from a series of historically large 75 basis points hikes. This move brought the benchmark rate to 4.25%-4.50% and the highest level in fifteen years.

Despite the downshift, the central bank maintained the guidance for "ongoing increases" and Chair Powell pressed on, as he called for a restrictive policy for "some time", stressing that "we're not in a sufficiently restrictive policy stance yet". ^[3]

In line with that, officials upgraded their view on the appropriate policy path on the updated Summary of Economic Projections (SEP), since they now expect rates to peak at a median of 5.1%. This is hefty bump, from the 4.6% peak of the previous and implies another 75 basis points of increases. More to it, seven of the nineteen participants, see the terminal above 5.25%. ^[4]

Tough Economic Outlook

The US Fed and the European Central Bank took a step back this week, as they try to assess the economic impact of their aggressive tightening and strive to balance competing forces. Inflation showed signs of easing recently in both the US and Eurozone, but both banks raised their forecast, which requires more rate.

The Federal Reserve now forecasts PCE Inflation to go as high as 3.5% in 2023 , from 3.1% previously projected, without expecting it to fall below the 2% before the end of 2022. The ECB raised its inflation forecast to 6.3% next year, from 5.5% previously, also expecting it to stay above 2% within the projection period. ^[5]

The US economy grew by an impressive annualized 2.9% in Q3 according to recent preliminary data and Eurozone expanded by more than expected (0.3% q/q), but both banks see a deterioration ahead which may limit their ability (or appetite) for more tightening.

The Fed now expects GDP to grow at a week pace of 0.5% next year, a far cry from the robust 1.2% it had previous projected. ECB officials see a "short-lived and shallow recession" in the euro area at the turn of the year and anemic growth of 0.5% in 2023.

ECB vs Fed

Fed Chair Powell pushed hard on the hawkish front calling for more hikes and essentially ruling out any cuts next year. President Lagarde on her part, emphatically dismissed any talk of pivot, pointing to aggressive tightening ahead.

Ms Lagarde seems to have been more aggressive though, while hinting to potentially 100 basis points of rate hikes ahead, compared to the Fed's 75 bps expectation. As such, this round goes to the ECB, which out-hawked its US counterpart.

However, the question is whether they will walk the walk and deliver the amount of tightening their rhetoric and projections suggest, or they will budge in the face of economic downturn.

The ECB's case seems to be more convincing, in the sense that it has more ground to cover than Fed, given its late start. However, it is quite fractious and Tuesday's guidance appears to be a potentially fragile compromise between policy makers who wanted bigger hikes and the ones who preferred a more moderate approach.