When the prices of gas, food and other goods and services jumped in May 2022 in the US, and consumer prices surged 8.6%, peaking at 9.1% year on year in June 2022 (a 40-year high), the US Federal Reserve (Fed) began raising interest rates aggressively to combat inflation. However, eurozone headline inflation came later to hit a new historic high of 10.7% in October 2022, driven primarily by Russia’s drastically reduced gas supplies to Europe and the greater impact of the armed conflict in neighbouring Ukraine, which included an influx of refugees.
As a result, in November of last year, the European Central Bank (ECB) embarked on its most aggressive monetary tightening in decades to curb the soaring inflation. By the start of 2023, the Fed, continuing its battle against inflation, had raised its benchmark fed funds rate by 425 basis points (bps), while the ECB had hiked its interest rate by 250 bps.
Stay the course on rate hikes
According to Economist Intelligence Unit’s (EIU) latest report, Global monetary policy in 2023, “More rate increases are coming, and we expect both regions to settle at peak interest rates by mid-2023.”
Following a cumulative 250 bps increase in policy rates since July 2022, EIU expects “The ECB to sanction another 150 basis points of increases in 2023 (50 basis points in both February and March, and 25 basis points in both May and June). Short-term interest rates will settle between 3.5% and 4% by mid-2023.”
As per EIU’s forecast, this will mean that the ECB will have ramped up its interest rates by 400 bps in the 12 months from July 2022 to June 2023, which is “More than double the pace of the last significant tightening cycle in 2005-08.”
ECB’s hawkish shift raises recession and fragmentation risks
As the ECB eased the pace of its interest rate hikes in December and laid out plans to drain cash from the financial system to fight against inflation, the bank significantly revised up their inflation projections “To an average of 8.4% for 2022, 6.3% for 2023 and 3.4% for 2024. Inflation was projected to average 2.3% in 2025”, observed the Governing Council of the ECB at the monetary policy meeting on December 14-15, 2022.
After the hawkish posture adopted at the December meeting, “Inflation across the euro zone declined to 9.2% year on year in December, from 10.1% in November, and the ECB expects price growth to remain above its 2% target for an extended period”, the EIU report explained.
“Although inflation is likely to ease steadily in 2023, we expect interest rates to stay at peak levels for some time—until mid-2024, at least—with important implications for GDP growth, bond yields, exchange rates and economic risks in both regions and the broader global economy. For now, we expect the Fed and the ECB to manage to tame inflation without prompting a deep global recession, but risks are high”, cautions the EIU report.
The first ECB rate cut is likely to occur in the third quarter of 2024, coupled with an environment of tightening financial conditions, which “Raises the risk of recession and financial fragmentation among euro zone members in 2023”, warns EIU.
European companies face a greater risk of insolvency in 2023
Weaker macroeconomic growth and rising interest rates will also mean that European corporate default rates are likely to rise in 2023.
In fact, as per the latest ECB financial stability review, “Corporate vulnerabilities are greater for energy-intensive firms which may face growing debt servicing problems.” These have been attributed to higher operational costs resulting in additional debt.
EIU estimates that “Higher interest rates will raise costs for firms on interest payments on their debt, especially for firms with a large share of debt negotiated at a variable interest rate or a short maturity.”
Non-financial corporations based in Italy and Spain are most exposed to variable-rate debt. According to Banque de France (the central bank of France), companies based in Italy and Spain have a much higher share of variable-rate and short-term debt than those in France and Germany, and they will therefore be exposed sooner to the current ECB monetary tightening cycle. The EIU report corroborates this, saying that “Only 47% and 62% respectively of the total outstanding corporate debt in Italy and Spain had a fixed rate as at end-2021, compared with 80% in Germany and 83% in France.”
Notwithstanding the fact that rising inflation and higher borrowing costs can test European households’ debt-servicing capacity, EIU forewarns, “We expect a further pick-up in corporate defaults in 2023, especially as the generous covid-related government support measures are gradually withdrawn, but not to the levels seen during the 2007-09 global financial crisis.”
To conclude, despite declining inflation rates, the core inflation remains high and the labour market resilient. This increases the possibility that ECB will “Over-tighten in early 2023, before any labour-market softening appears”, as per EIU, and if that happens, it will likely result in falling consumer demand and exacerbated energy price shock, pushing the eurozone into a deeper recession later in the year.
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