The ECB is in a rather unenviable spot ahead of their policy decision later today.

It is clear that the central bank will deliver a rate hike, bringing the deposit facility rate to 2.25%. But in the context of the bigger picture and the fight against inflation, how far do they need to go in terms of tightening policy further from here? Now, that is the real question.

The issue with the kind of inflation shock we’re seeing is that it is not one that monetary policy is well-equipped to deal with. It has always been the case before with any supply shock and/or negative demand shock.

A rate hike by the ECB today will not help to resolve the Middle East conflict. And it sure will not do anything to help to reopen the Strait of Hormuz and end the disruption to the oil and gas market as well as that to global supply chains.

The only thing they can do is look to buy more time and hope to get more clarity surrounding future decisions. In essence, they want the flexibility and optionality to react to any potential second-round effects to inflation if that were to happen.

As such, the rate hike today is very much just an “insurance” one or a mere posturing play.

As a reminder, ECB policymakers have ascertained that the neutral range estimate is around 1.75% to 2.25% (more dovish members) or 2.00% to 2.50% (more hawkish members).

So in bringing the deposit facility rate back to 2.25%, it is still sitting within the realms of neutral territory. And even if raising rates further to 2.50%, that will just bring it back to marginally restrictive at best.

If the ECB is seriously worried about inflation running away, this won’t be a one and done. And the risk here is that the ECB may have to be forced to tighten policy a lot more while going up against a deteriorating economic backdrop.

As mentioned before:

“Credibility concerns aside, this is a potentially dangerous situation as it risks inflation running away especially if we start to see second-round effects come into play.

So, what exactly does 50 bps of rate hikes do in this instance? By their interpretation, that brings interest rates back to just marginally restrictive territory at best. Is that really enough to bring inflation back down especially with the risk of second-round effects coming in?

As we saw with the Russia-Ukraine crisis, it’s going to take much more than that. And therein lies another set of risks if the ECB moves too slowly to act.

Even if not being very clear at the moment, it must be said that one policy misstep is enough to send the economy on a recession spiral or if not an inflation one. And that’s a very, very tough position to be in.”

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