4 reasons why the ECB will tighten policy faster than the market expects

This week’s main event is the European Central Bank (ECB) ‘s decision on Thursday. The ECB is in a tough spot, as inflation is running hot in the euro area, and the war in Ukraine sent energy prices through the roof.

While it did raise the key interest rates from negative territory, the ECB is still lagging compared to what other central banks did. Is it possible that the central bank will take the market by surprise and tighten the policy faster?

Here are four reasons why it might just do that:

• Inflation in the euro area remains elevated
• Consumer credit continues to expand
• Inflation expectations are also moving higher
• Record low unemployment rate

Since Russia invaded Ukraine in February this year, energy prices have increased. As a result, they caused higher inflation, much higher than the ECB can tolerate.

But it is not only about energy prices.

For instance, the official core EUR reading is at 4.3%, exceeding the ECB target. Moreover, producer prices in the euro area have gone parabolic recently, and the rise typically is transmitted to the consumer in the period ahead.

Another reason the ECB might tighten faster than expected is that consumer credit still expands. It suggests that monetary policy is too easy, giving the ECB another incentive to tighten it.

Inflation is high in the euro area and is a problem for households and the central bank’s credibility. Also, inflation expectations are high and moving higher.

For many central banks, inflation expectations are more important than the actual inflation rate. If not anchored, they could easily translate into higher prices for goods and services and actual inflation in the period ahead.

Finally, the unemployment rate in the euro area is at a record low. A robust labor market gives the green light to the ECB to tighten the policy even though it might end up tightening in an economic recession.

All in all, the ECB has a chance to go big on Thursday, and the Governing Council probably will. Will the common currency bounce from the current levels?

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