Wed, Nov 30, 2022 @ 14:48 GMT

ECB Must Act, Now

A big week for the global central banks

The Reserve Bank of New Zealand and the Bank of Canada both raised their interest rates by 50bp this week. For both banks, this was the biggest hike in more than two decades, as the policymakers stepped on the gas to fight back the soaring inflation.

The latest policy decisions from the G7 central banks cement the idea that the Federal Reserve (Fed) will announce at least a 50-bp hike in its next meeting, and increase the pressure of a concrete rate action from the European Central Bank (ECB).

Activity on the fed funds futures assess an almost 90% probability for a 50bp hike in May, completed with a $95 billion Quantitative Tightening to make sure that inflation tops near the actual 8.5%.

Yesterday’s data showed that the US producer prices jumped by more than 11% in March, the highest since 2010, but the US indices rebounded on the belief that we could be approaching a peak in the actual higher inflation cycle as the pandemic-related distortions begin to fade, and the comparison to the depressed pandemic months will be replaced by the months of decent spike energy prices. So the base effect should play an important role in the coming months’ reads. Though inflation will certainly remain at significantly higher levels of 4-5%.

Inflation, inflation

Inflation in Britain hit 7% in March on the back of soaring food and energy prices and is seen to advance to 9% as soon as next month, while inflation in Europe hit unusually high levels as well, with the German inflation advancing to 7.6% in March.

The rising inflation will certainly lead to heated discussions at the heart of the European Central Bank’s committee at today’s policy meeting. The ECB plans to end the asset purchases by Q3 and hike the rates soon after.

But the ECB doesn’t have the option to wait until the last quarter to hike rates; it must raise the interest rates by end of summer, the latest, even though inflation is caused by supply side problems that can’t be effectively addressed with restricting demand.

If the ECB doesn’t act, the tighter monetary policy from other major central banks will send the value of euro crushing, which would add an additional pressure on inflation.

The EURUSD rebounded past the 1.09 level after trading close to the 1.08 support yesterday. A reasonably hawkish ECB could send the EURUSD above the 1.10 mark sustainably, but a soft response from the ECB will likely send the single currency below the 1.08 as the bears will be targeting the 1.05 level next.

And if the ECB insists ending the bond purchases in Q3 and hiking the rates by the end of the year, then we shall see the euro fall to parity against the US dollar this year.

China and Turkey swim against the tide

The overall trend is tighter central bank policies and higher rates, but two countries defy the laws of gravity.

China is expected to cut its key policy rate for the second time this year on Friday to give support to its economy that is ravaged by an unrealistic zero Covid policy. The People’s Bank of China will likely cut the reserve requirement ratio as well to increase the amount of cash in circulation.

The Central Bank of Turkey, on the other hand, is headed toward more uncertainty. According to the latest unofficial data, inflation in Turkey advanced to more than 142% in March, but the central bank is not expected to raise its interest rate that stands at 14%. It’s a time bomb.

For now, Turkey compensates the saving accounts in accordance with the loss of value in USD terms, and it costs the country an arm, of course, to keep the dollar-lira rate steady. The cost of conducting such an irrational policy is so high that the country is thinking of issuing a ‘super bond’ to finance the messy policy.

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