Benchmark Rate Hike In Sight by Christoph Sax

The European Central Bank has opened the door to tightening monetary policy. This provoked an upward push in medium and long-term rates. A rise in key interest rates is therefore likely, including in Switzerland.

Rising energy prices pushed the inflation rate in the Eurozone up from 5.0% to 5.1% in January. Since several extraordinary interventions will fail in the medium term, inflation should decrease significantly in the second half of the year. However, the inflationary outlook remains uncertain, also because the relaxation of the protective measures against Covid-19 will give a further boost to the European economy. In February, Christine Lagarde, President of the European Central Bank (ECB), was forced to open the door to a tightening of monetary policy. As a result, long-term rates have risen sharply.

The ECB takes action sooner than expected

Lagarde's hint of a possible hike in key interest rates came earlier than expected, especially as core inflation in the monetary union of 2.3% remains close to the long-term inflation target of the monetary union. ECB. Up to now, a much more hesitant reorientation of monetary policy had been envisaged, drawing attention to the temporary factors of inflation, which would diminish over the course of the year.

Initially, the ECB is expected to stop, or at least significantly reduce, bond purchases. The reference rate (currently equal to -0.5%) is expected to increase only in the second half of the year. This will also offer the Swiss National Bank (SNB) leeway to raise policy rates. The SNB is likely to act in sync with the ECB. This would be the first tightening of monetary policy by the Swiss National Bank in the past two decades.

Short cycle of rate hikes

However, the key rates in the Eurozone will not rise as much as in the United States. The rapid rise in energy prices (see graph) is a consequence of strong global demand and political tensions with Russia. Supply bottlenecks also have global causes, most notably excessive fiscal stimulus by the US government, which has led to a massive increase in private consumption. The ECB cannot influence these mechanisms.

Added to this is a base effect that contains inflation over the course of the year. The inflation rate measures the change in prices compared to the reference period of the previous year: if energy prices stabilize at a high level already now, inflation in the Eurozone should fall by around 2 percentage points within a year. If they even register a decrease, the decline in inflation will be even more marked.

The rise in key rates should give impetus to the euro. A stronger single currency will also reduce inflationary pressures in the euro area and curb economic growth. In 2017/2018 the euro / franc exchange rate had temporarily recovered to 1.20, after the then president of the ECB Mario Draghi had envisaged a change in monetary policy. However, due to the trade conflict between the United States and major trading partners, the ECB was unable to raise the benchmark rate. Even now, the ECB is faced with a dilemma: if the economy were to deteriorate as in 2019, the credit spreads of the peripheral countries would increase and the ECB would be forced to take countermeasures again.

Migros Bank therefore expects that the ECB, and consequently the SNB, will not raise the key interest rates excessively. The ECB will seize the opportunity, but will have to proceed with caution. On the capital market, long-term rates have already anticipated a substantial part of the imminent upward movement in key rates (see chart). The Swiss franc yield curve is therefore expected to flatten out. The current inflationary push should prove to be largely temporary, but inflation is likely to remain slightly higher than in the pre-crisis period.

Christoph Sax

Christoph Sax is the chief economist of Migros Bank. He prepares forecasts concerning the economic trend and developments on the financial markets.

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