Will ECB Policy Hit Its Mark?

The European Central Bank (ECB) stepped up its battle against inflation at its latest meeting on July 21, raising policy rates by 50 basis points instead of the expected 25. But the eurozone also faces the risk of diverging sovereign borrowing costs — particularly given political uncertainty in Italy — and the threat of shortages in the gas supply that could lead to another supply shock.

Revisiting our scenarios

Amid this uncertainty, we take a step back and look at four scenarios about eurozone inflation and ECB monetary policy focused on a medium-term horizon and based on assumptions for macroeconomic shocks and central-bank-policy strength and credibility with the public. While markets can be volatile in the face of current uncertainty, these scenarios focus more on the macroeconomic fundamentals and may take longer to play out.

Since the Russia-Ukraine war started in late February, we have seen market moves which are directionally aligned with our “Stagflation” scenario: nominal and breakeven inflation (BEI) rates and credit spreads increased while European equities and the EUR/USD exchange rate dropped. Since the ECB’s June policy meeting, market-implied inflation expectations and nominal rates have decreased, but equities and the euro continued to slide, and Italy’s sovereign spread widened further — events more aligned with the “Slowing growth” scenario.

What now?

The question for investors is whether the ECB’s rate hike could bring inflation down at the cost of “Slowing growth” or whether we are headed for the grimmer “Stagflation” outcome. According to our scenarios, for a diversified portfolio with European equities, bonds and real estate, the “Slowing growth” scenario could result in a -2% medium-horizon return. This is far better than the 10% loss under “Stagflation.” Whether or not an additional energy-supply shock occurs may be a crucial factor to watch.