WeekWatch -‘As inflationary pressures continued to mount last week, the European Central Bank (ECB) revealed it would raise its key interest rate by 0.25%’ June ’22

As inflationary pressures continued to mount last week, the European Central Bank (ECB) revealed it would raise its key interest rate by 0.25% at its July monetary policy meeting.

This will mark the first rate rise in the region in over a decade.

As the ECB’s rate is currently -0.5%, even after this increase, it will remain negative. But with inflation looking persistent, the Bank also said it expects to raise interest rates again in September, meaning rates could turn to zero or become positive.

In May, inflation hit 8.1% in the EU – far exceeding the Bank’s target of 2%. The ECB said it expects inflation to average 6.8% for 2022, falling to 3.5% in 2023 and 2.1% in 2024. This is higher than its previous projections.

“Russia’s unjustified aggression towards Ukraine continues to weigh on the economy in Europe and beyond. It is disrupting trade, is leading to shortages of materials, and is contributing to high energy and commodity prices,” President of the ECB Christine Lagarde commented.

“These factors will continue to weigh on confidence and dampen growth, especially in the near term. However, the conditions are in place for the economy to continue to grow on account of the ongoing reopening of the economy, a strong labour market, fiscal support and savings built up during the pandemic.”

Although the ECB has so far been slower than the UK and US in raising its rates, several commentators said they expect the rate rise in September to be larger than 0.25%. Increasing interest rates typically slow the performance of ‘growth’ company shares – such as those in the technology sector and may lead to a rotation towards more ‘value’ orientated companies.

“The ECB is unwilling to do 50 basis points in July mainly because they don’t want to take rates to zero in one go. Ms. Lagarde referred to the need for a gradual first step in lifting interest rates, referring to 25 basis points as “good practice,” said Claus Vistesen, Chief Eurozone Economist at Chief Eurozone Economist Pantheon Macroeconomics.

“50 basis points in September seems like a done deal. The President explicitly said that if the medium-term inflation expectations remain unchanged, they will hike by 50 basis points. We doubt that the central bank will be in a position to lower its medium-term inflation outlook by September, and as such, we have to believe in a 50bp hike,” he continued.

With high inflation and incoming rate rises, it is perhaps unsurprising that European markets struggled last week. The MSCI Europe ex. UK index closed the week -4.4% lower.

In the US, markets also continued to struggle.

After the US Bureau of Labor Statistics revealed inflation hit 8.6% in May – notably higher than many expected and the highest rate since 1981 – the S&P 500 and the NASDAQ fell, ending the week down 5.1% and 5.6% respectively, their worst weeks since January.

While this may sound alarming, Mark Dowding, Chief Investment Officer at Bluebay, thinks the medium-term situation doesn’t look quite so dire.

“US economic activity data remains relatively healthy, and with consumer and business balance sheets in strong shape, we continue to see recession as a risk case, rather than a central probability. Further evidence of the underlying strength of the US economy is shown in fiscal data, with the US Federal deficit shrinking at a rapid rate.”

The economic situation in the UK is also experiencing economic headwinds. The very start of this week revealed the UK’s GDP unexpectedly shrunk in April by 0.3%, prompting fears the UK may experience a recession this year.

In reaction, Tony Danker, the Director-General of the Confederation of British Industry said: “Let me be clear – we’re expecting the economy to be pretty much stagnant. It won’t take much to tip us into a recession. And even if we don’t, it will feel like one for too many people.”

With the Bank of England due to meet later this week, it seems likely further interest rate rises are on the cards.

Bluebay is a fund manager for St. James’s Place.