A big week for monetary policy

Chris Scicluna
Emily Nicol

ECB to raise rates and discuss new anti-fragmentation policy tool; Italian politics first to set the mood with autumn elections possible
A big week in the euro area will bring the first ECB rate hike since the ill-fated tightening of 2011 on Thursday. In addition, the Governing Council will discuss plans for a new anti-fragmentation tool that would seek to use targeted asset purchases to prevent any widening of spreads that was both inconsistent with fundamentals and risked impairing the transmission of monetary policy. However, the day before the Governing Council meeting concludes, political events in Italy are scheduled to come to a head, determining whether the Draghi government will collapse before the release of the country’s latest tranche of EU funds and a snap general election will be held in the autumn. In particular:

The ECB’s interest rate decision seems most straight forward. The Governing Council already stated in June that it would raise all of its rates by 25bps this month. So, while an economic case exists for a larger hike – after all, euro area inflation in Q2 of 8.0%Y/Y was already 0.5ppt above the ECB’s forecast published last month – a decision on Thursday to hike by more than that would damage the credibility of its guidance in future. So, the deposit rate will be merely hiked to -0.25%, maintaining the incongruity of negative interest rates despite record high inflation. The Governing Council will nevertheless continue to signal that rates will rise by a larger albeit unspecified increment in September (unless the inflation outlook has markedly improved by then, which seems highly unlikely), maintaining the possibility of a hike greater than 50bps at that meeting. Given the highly uncertain economic outlook, not least related to the supply of natural gas from Russia, the Governing Council might say little new regarding the rate profile in Q4 and beyond, likely maintaining its current guidance that it anticipates “a gradual but sustained path of further increases in interest rates”.

In light of the political shenanigans in Italy, the ECB’s hawks seem likely to ensure that the terms of the anti-fragmentation tool – reportedly to be called the Transmission Protection Mechanism – are not overly generous (if they are agreed at all), ensuring that the new instrument has visible safeguards against moral hazard. So, the criteria for triggering activation of the tool - related in part to the calculation of the level of spreads consistent with fundamentals – are likely to be constructively ambiguous. In addition, while bond purchases conducted under the policy might theoretically be unlimited in size, the hawks will want policy conditionality attached to the use of the new mechanism to be meaningful, and at a minimum linked to full consistency with EU policy guidance, albeit looser than that attached to the Outright Monetary Transactions (OMT) instrument which requires an ESM programme also to be in place. Finally, the Governing Council should also agree how the liquidity impact of any asset purchases conducted under the policy tool will be neutralized, e.g. by offering a higher interest rate on term deposits, determined at auction.

By the time of the ECB policy announcement, BTPs – which continue to underperform this morning – could be under significant downward pressure if Draghi’s resignation and snap elections for the autumn are confirmed on Wednesday. The weekend offered no new clues to suggest that a deal might be found to persuade Draghi to remain Prime Minister, with the centre-right League and Forza Italia seemingly joining the Five Star Movement in moving closer to preparing for elections. Given the difficulty fathoming what is going on behind the scenes, and the capricious nature of all the main Italian political protagonists, however, we do not rule out the possibility that a deal might be secured to give the Draghi government a second wind.

BoJ to stick with current policy stance, despite revising up its inflation outlook; June goods trade and CPI reports also due
The BoJ’s latest Policy Board meeting will also conclude on Thursday, although this is likely to be less eventful than the ECB’s. BoJ Governor Kuroda has repeatedly stated over recent weeks that Japan’s ultra-accommodative policy stance remains appropriate given the economic uncertainties and the softer inflation outlook in Japan than elsewhere. In addition, in light of PM Abe’s assassination this month, now would hardly seem the appropriate time to start removing one of his key “three arrows”. And so, like the majority of observers, we continue to expect that the key policy parameters of the Yield Curve Control framework will be left unchanged this week. Nevertheless, recent increases in Japanese inflation expectations, and the awareness that the other major central banks repeatedly underestimated the outlook for inflation in successive projections, will place the BoJ’s own forecast update under significant scrutiny. Indeed, in its latest Outlook Report, we would expect it to revise notably higher its current inflation forecast of 1.1% in FY23 and FY24. However, given events abroad, the BoJ will also be extremely wary of downside risks to economic growth into next year.

In terms of Japanese data, Thursday’s goods trade release is expected to show that the deficit widened further in June to a new record high, with the value of imports continued to be pushed higher by imported energy prices. Meanwhile, Friday will bring the latest consumer price inflation numbers. While the headline inflation rate is expected to have edged slightly lower (by 0.1ppt to 2.4%Y/Y), the BoJ’s forecast core measure – excluding fresh foods – is expected to have risen 0.1ppt to 2.2%Y/Y, the highest since January 2015. The end of the week will also bring the flash PMIs for July.

Final June CPI and flash PMIs the euro area data focus this week
In terms of euro area economic data, tomorrow will bring an updated estimate for inflation in June, with the headline HICP rate expected to confirm the 0.5ppt increase initially estimated, taking it to a record high of 8.6%Y/Y. But reflecting German policy measures to reduce the cost of public transport, and summer discounting on clothing, core inflation is also expected to have declined 0.1ppt to 3.7%Y/Y. July sentiment indicators will be the focus in the second half of the week, with the European Commission’s flash consumer confidence index (Wednesday) likely to have fallen closer to the record low logged at the onset of the pandemic in April 2020. Meanwhile, the flash PMIs (Friday) will be watched for a further deterioration in business conditions at the start of the third quarter – in June, the euro area composite PMI fell to a sixteen-month low (52.0), with the new business component signalling no growth. Separately, the ECB will publish tomorrow its latest quarterly bank lending survey for Q2, which will likely report a tightening of lending conditions amid expectations of imminent monetary tightening.

UK labour market, CPI, retail sales, flash PMIs and politics all in focus
A busy week ahead in the UK, with arguably June’s inflation data (Wednesday) to attract most attention. Given the surge in petrol prices over the past month, we expect energy inflation to have taken a further step up in June, with food inflation rising to its highest since 2009. As such, we expect headline CPI inflation to have increased 0.3ppt to 9.4%Y/Y, the highest on the series dating back to 1997. But core inflation is expected to have moved sideways at a still-lofty 5.9%Y/Y, as a pickup in services inflation might have been offset by a temporary easing in non-energy industrial goods inflation. Ahead of this will bring labour market figures (tomorrow), which are expected to report ongoing solid employment and wage growth, albeit leaving the unemployment rate unchanged at 3.8% in the three months to May and real wage growth firmly in negative territory. Against this backdrop, we expect total retail sales to have declined further in June, while the bank holiday boost to food sales at the start of the month was countered by the drop in retail footfall during the public transport strikes. Friday’s GfK consumer survey is also likely to suggest that household confidence remains close to record lows in July with little appetite for major purchases. And the flash PMIs are unlikely to see any improvement in business conditions at the start of Q3 too.

Of course, UK politics will remain in focus, as the number of Conservative party leadership candidates are reduced to the final two (by Wednesday), whose names will be submitted to a vote among the party membership over the summer before the result is announced on 5 September. Former Chancellor and more fiscally-conservative Rishi Sunak looks set to reach the final two, although it is yet unclear whether he will then face Trade Minister Penny Mordaunt or Foreign Secretary Liz Truss as the standard-bearer for the party’s populist right wing.

US housing market figures in focus this week
A quieter week for US releases will focus on the housing market, kicking off today with the NAHB index for July, followed by June housing starts and existing home sales figures (tomorrow and Wednesday respectively). Elevated inventories and the prospect of slowing sales likely saw builders trim single-family housing starts for the sixth month out of the past seven. But while a pickup in pending home sales suggests that sales of existing home were more stable last month, this follows a cumulative drop of roughly 16½% in the previous four months. The back end of the week will bring the Conference Board’s leading indicators for June, as well as the flash PMIs for July. 

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