Representatives of the world’s largest central banks will gather for the first meetings of 2023 after a break in early February. Although since the beginning of autumn, the US Federal Reserve System (FRS) and the European Central Bank (ECB) maintained the same pace of raising rates, judging by the statements of bank representatives and financial market forecasts, this dynamic could change in February.
The latest forecasts show that the FRS could raise the dollar rate by 0.25 percentage points in early February, thus reducing the previous rate hike from the 0.50 percentage points that was fixed in December. Meanwhile, the ECB could save a flat rate by continuing to raise euro rates by 0.50 percentage points. Thus, the ECB deposit rate could reach 2.5% in February, while the refinancing rate – 3% of the area.
At what rates could the US and Europe stop?
In the near term, the ECB could maintain a more aggressive stance than the FRS. According to futures market forecasts, the highest level of the dollar rate could be reached soon – at 4.75 – 5.00% (currently – 4.25 – 4.50%). FRS plans to stop at the 5.00 – 5.25% area. Meanwhile, in the eurozone, rates could continue to rise for some time to come. After the forecast increase of 0.50 percentage points in February, the market expects that euro rates will be raised by a similar amount in March and one or two more times by 0.25 percentage points. Thus, the ECB deposit rate could rise to 3.25 – 3.50% in the summer (currently – 2%). Accordingly, interbank interest rates could also peak close to these levels.
Seeing the ECB’s more aggressive mood, financial market participants have also started predicting higher euro rates this year. The view on rates in the longer term has not changed significantly, predicting that in the next 2 – 3 years the ECB’s base rates and correspondingly also the 3-month EURIBOR will stabilize at 2.5%, 6-month – slightly higher. At these levels, rates will continue to restrain economic activity rather. Therefore, it is not excluded that in the longer term they could return closer to neutral levels, which neither accelerate nor limit growth. According to ECB estimates, it is around or slightly below 2%. At the same time, we can forget about zero rates for now. A return to them would mean a severe crisis in the Eurozone, which is not currently on the horizon.
What explains the ECB’s aggressive approach?
Why is the ECB continuing to raise rates aggressively when the main drivers of inflation in the eurozone – resource prices – have fallen below pre-war levels in financial markets in recent months? Record-high core inflation, or price increases without more volatile changes in energy and food prices, is a factor that makes the ECB feel uncomfortable and prevents it from thinking about releasing the gas pedal. At the end of 2022, inflation in the eurozone reached 5.2%. This figure still partially reflects previous increases in resource prices, which affected both the prices of services and the cost of producing goods. Despite the records, inflation expectations in the Eurozone are not high. Judging by moderate wage growth, a disastrous spiral of inflation is also not observable. But in a high-inflation environment, this can change quickly, so the ECB is afraid to loosen the reins of monetary policy too soon.
The second and no less important factor for the ECB is the euro. The ECB’s more aggressive rhetoric compared to its counterparts on the other side of the Atlantic Ocean, among other factors, also contributed to the strengthening of the euro currency. After stumbling below parity against the dollar last fall, the euro has appreciated more than 10% against the US currency over the past three months. Although negative for exporters, a stronger euro helps the ECB in its fight against inflation by easing pressure on resource prices, which are usually traded in dollars. As the euro becomes more expensive, resources and other imported goods become relatively cheaper in euro terms.
The pressure will continue to be felt in Latvia as well
Each rate hike by the ECB via EURIBOR inevitably affects every borrower in Latvia who has variable loan interest rates. EURIBOR rates are already largely factoring in the ECB’s February rate hike. The 3-month EURIBOR rate is approaching 2.5%, the 6-month rate is close to 3%. The expected increase in euro rates by 0.50 percentage points in February will make the monthly payment of a mortgage loan more expensive, on average, from a few to 5% of the monthly payment amount, depending on the term of the obligation and the repayment schedule of the loan. For example, for a loan of 50 thousand euros, this would mean an increase in the monthly loan payment by an average of 10 – 15 euros per month.
