Interest rates in the Eurozone may rise again, depending on the European Central Bank’s (ECB) willingness to signal its stance against the energy price shock, according to Pimco expert Konstantin Veit.
Peder Beck-Friis, Europe economist at fund company Pimco, notes that the current energy market situation creates significant uncertainty. The sharp increase in crude oil and natural gas prices has substantially raised inflation expectations, fueling fears that this price rise could permeate the entire European economy.
Risk of Second-Round Effects?
However, Beck-Friis emphasizes that fears of “second-round effects,” similar to those seen during the previous inflation surge in 2021-2022, are likely exaggerated. He cites two main reasons for this. Firstly, the labor market is in a considerably weaker state. While previously dominated by a shortage of skilled workers, the current weak growth poses a greater risk of unemployment. This reduces workers’ bargaining power for higher wages, thus decreasing the likelihood of a wage-price spiral. Secondly, Beck-Friis points to the absence of a “strong fiscal response” to the energy price shock, as few European countries currently have the financial flexibility for large-scale aid packages like those seen during the pandemic.
Interest Rates: Market Has Clear Expectations
The question for economists is whether central banks will “look through” the inflation, considering it short-term and leaving monetary policy unchanged. The market’s current answer is no. Market participants anticipate two 25-basis-point interest rate hikes from the European Central Bank (ECB) this year. Portfolio manager Konstantin Veit stated that an interest rate hike is possible at the next ECB Governing Council meeting on April 30th, and a hike for June is already fully priced in, a view he agrees with.
Veit referenced recent statements by ECB Chief Economist Philip Lane. Lane had previously placed the neutral interest rate, at which monetary policy is neither expansionary nor contractionary, in a range of 1.75% to 2.25%. The current main refinancing rate of 2.0% would therefore be in the middle of this neutral range. However, Lane has now positioned the upper limit for the neutral rate at 2.50%, meaning a main refinancing rate of 2.25% would still be neutral. “The ECB must make a decision whether it wants to remain neutral or not,” Veit said. “It must send a signal that inflation expectations remain firmly anchored.” Anchoring means people expect a stable inflation rate of two percent in the medium to long term.
In response to the energy shock triggered by the conflict in Iran, market expectations for the ECB have shifted from “constant” to “hike.” For the US Federal Reserve (Fed), constant monetary policy is expected instead of rate cuts. However, Andrew Balls, global chief investment strategist for fixed income at Pimco, warned that the Fed must closely monitor the situation due to the “risk of rising inflation expectations.”
