Projected ECB interest rates in 5 years: Can euro survive biggest test yet?

Inflation rate in the eurozone area broke to a new record of 8.9% in July. The latest inflation reading showed that the European Central Bank (ECB)’s first rate hike in 11 years has not yet tamed the unchecked inflation.

Will stubbornly sky-high inflation be a strong reason for ECB to have a larger hike when it convenes for monetary policy meeting on 8 September? 

If the ECB continues its hawkish monetary tightening, what will the projected ECB interest rate be in 5 years?

In this article, we examine the history of ECB rate hikes and factors that will affect ECB interest rate decisions, such as inflation, gross domestic product (GDP) growth, and unemployment rate. These factors will help analysts to draw the ECB interest rate forecast. 

What is ECB?

ECB stands for the European Central Bank (ECB). It is the central bank in charge of monetary policy in the European Union (EU) member countries that use the euro (EUR). This currency union, which now includes 19 countries, is known as the eurozone.

Based in Frankfurt, Germany, the ECB has overseen the euro area’s monetary policy since the adoption of the euro on 1 January 1999.

The primary mandate of the European Central Bank is to maintain price stability in the eurozone by ensuring that inflation does not exceed 2% in the medium term. As a central bank, it controls inflation by changing its ECB interest rates, either raising them to discourage spending or lowering them to encourage consumption.

Monetary policy decisions are made by the ECB's Governing Council, which is composed of the six members of the Executive Board and the governors of the national central banks of the eurozone's 19 member countries.

The council meets twice a month at the ECB's headquarters. It assesses the state of the economy and the currency every six weeks and makes monetary policy decisions.

In non-monetary policy meetings, the council discusses the ECB's and the eurozone's other tasks and responsibilities. Other ECB responsibilities include supervising eurozone banks, monitoring the financial system, printing euro banknotes, ensuring secure payment in euro by card or online, and investigating crypto assets.

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ECB uses three rates in its monetary policy instruments toolkit:

1. The interest rate for the main refinancing operations (MRO) is the ECB key rate, the ‘refi rate’ which applies when banks borrow money on a weekly basis from the ECB in exchange for security and at a predetermined interest rate.

2. The interest rate on the deposit facility, which banks may use to deposit funds overnight at a rate that is lower than the rate for the ‘refi’ rate

3. The marginal lending facility's interest rate, which provides overnight credit to banks at a pre-set interest rate above the main refinancing operations rate.

ECB interest rates history shows that the central bank began its low-interest rate policy in October 2008 by cutting its main refinancing operations interest rate by 50bp to 3.75% amid the global financial crisis.

From 2008 to 2012, the central bank had several hikes and cut the refi rate several times that brought the rate at 1% by July 2012.

Between July 2012 and September 2014, the ECB lowered its refi interest rate four times, bringing it down to 0.05% from 1% in July 2012. It kept the 0.05% rate until March 2016, when it reduced it by 5 basis points to 0.00%, according to the European Central Bank interest rate history data.

The ECB maintained its zero-interest rate policy until 27 July 2022, when it raised interest rates for the first time since 2011 to curb the eurozone’s runaway inflation. 

European Central Bank interest rates in 2022

The Governing Council decided to raise the three key European Central Bank interest rates by 50 basis points in a meeting on 21 July.  The ECB raised interest rates on the main refinancing operations, the marginal lending facility, and the deposit facility to 0.50%, 0.75%, and 0.00%, respectively, according to a statement issued on 21 July.

The annual inflation in the Eurozone area surged to a record high of 8.6% in June, rising from 5.1% in January 2022 and 1.9% in June 2021, according to Eurostat figures. 

The inflation reading surged to a fresh record of 8.9% in July, Eurostat latest data shows. Energy remained the highest annual rate contributor in July, followed by food, alcohol, and tobacco as main sectors driving up the inflation.

Key factors affecting ECB rate decision

Central banks typically make interest rate decisions based on inflation, growth domestic products (GDP), and unemployment rate readings. What is the long-term outlook for these three metrics that will help the ECB to decide on the eurozone interest rate?

Inflation seen cooling

In its Summer 2022 economic forecast, ECB forecast that annual average inflation could peak at historical high in 2022 at 7.6% in the euro area and 8.3% in the European Union. Protracted Russia’s invasion of Ukraine has kept energy and food prices elevated, said the Bank. 

The inflation rate was expected to ease to 4.6% in the EU area and 4.3% in the euro area in 2023 as the pressure from energy prices and supply constraints fade. The ECB did not have an inflation forecast beyond 2023. 

ABN-AMRO on 4 August also revised up its eurozone inflation for 2022 to 8.3% from 7.4%, Aline Schuiling and Nick Kounis, the bank’s economist, wrote in a note. 

The upward revision was mainly caused by trickling Russia’s gas flows which have not returned to levels that would prevent an energy crisis following the annual maintenance to the Nord Stream 1 pipeline in July.

ING Group forecast inflation in the eurozone to peak at 9.5% in the third quarter, cooling to 8.8% in the last quarter of 2022 and 6.7% in the first quarter of 2023, the Dutch lender wrote in its projections updated on 5 August. 

On an annual basis, ING forecast inflation in the Eurozone to average 8.1% in 2022, plummeting to 3.5% in 2023 and 2.2% in 2024. 

In the ECB Survey of Professional Forecasters (SPF) for the third quarter of 2022, participants revised up the HICP [Harmonised Indices of Consumer Prices] inflation forecast for 2022 by 1.3 percentage point to 7.3% from the second quarter estimate. They also increased inflation projections for 2023 by 1.2 percentage points to 3.6% and by 0.2 percentage points to 2.1% in 2024. 

The upward revision of inflation rates were mainly caused by energy and food prices.

Respondents in the survey also cited weaker euro, particularly against the US dollar and tight labour markets as the factors for the upward inflation forecast. 

“At the same time, some respondents noted that some of the global value chain disruptions and the prices of some (primarily) non-energy, non-food commodities, such as metals and other industrial raw materials, were showing tentative signs of peaking or even easing.”

For longer-term inflation expectations respondents also revised up inflation for 2027 to average 2.2%, from 2.1% in the previous survey (for the second quarter of 2022). 

GDP to slow in near term 

For gross domestic product (GDP), ECB forecast real GDP in the EU to grow by 2.7% in 2022, slowing to 1.5% in 2023. GDP growth in the euro area was also estimated to slow from 2.6% in 2022 to 1.4% in 2023. 

ECB did not provide forecasts beyond 2023.

ABN-AMRO expected the Eurozone economy to grow at 2.7% in 2022, slower than its previous forecast of 2.9% for the year. In 2023, the Eurozone is forecast to register negative 0.9% growth, compared to the bank’s previous estimate of 1.3% for the year. 

“Declines in consumption and investment and the resulting contraction in GDP in the coming quarters would also be in line with recent survey indicators, such as the sharp drops in eurozone consumer confidence, business sentiment and composite PMI (Purchasing Manager Index) in recent months,” the bank’s economist Schuiling and Kounis said.

ING estimated eurozone GDP to slow to 0.6% in the last quarter of 2022, from 1.4% in the third quarter and 4% in the second quarter. The economy hit a break with negative 0.1% in the first quarter. Annually, the eurozone's economy is expected to grow by 2.8% over 2022, plunging to 0.1% in 2023 and recovering to 1.5% in 2024. 

Respondents in the ECB’s third quarter survey revised down the eurozone’s GDP by 0.1 percentage point to 2.8% in 2022. It estimated EU’s GDP growth by 1.5% for 2023 before picking up slightly to 1.8% for 2024 which represented downward revisions of 0.8 percentage points for 2023, and no change for 2024.

The participants increased their forecast for longer-term growth by 0.1 percentage point to 1.5% in 2027.

Unemployment rate to fall to lowest level

In the ECB’s survey respondents forecast the unemployment rate in the eurozone to steady at average 6.7% in 2022 and 2023. The percentage of the number of unemployed people is expected to drop slightly to 6.6% in 2024 and drop further to 6.4% in 2027. 

The forecast for unemployment rate in 2027 is the lowest rate ever recorded for long-term unemployment expectations, according to the survey.

Respondents explained that the smaller downward revisions after 2022 were due to the impact of lower economic activity expectations.

“High inflation, which is reducing real disposable incomes and consumption as well as feeding into wages, was mentioned as the main upward risk for unemployment. By contrast, robust labour markets, demographic factors and labour shortages in certain sectors were frequently mentioned as downward risks. Unlike the previous round, the war in Ukraine and migration were not explicitly mentioned as factors affecting the unemployment rate forecasts,” according to the survey. 

Projected ECB interest rates in 5 years

ECB suggested it may have more than 25bp rate hike in its September meeting if inflation reading does not show any signs of abating, the European central bank said in its Summer 2022 economic forecast. 

“Beyond that, the ECB anticipates a gradual but sustained path of further increases in interest rates,” the Bank said in the report.  

Based on the period between 17 and 30 June used for its forecast, markets expected the euro-area short-term rates to increase by a total of 190bp between July and the end of 2022. The ECB interest rate is projected to increase further by around 90bp by the end of 2023. 

“Since then, markets have shifted their expectations towards more modest increases in short-term rates, reflecting a grimmer economic outlook that would require a less forceful tightening by the central bank,” ECB said.

ECB interest rate is expected to have another 50bp increase in the September meeting and continue to hike the rate by smaller 25bp each in October and December by 25bp each, according to ABN-AMRO’s forecast. After that, the European central bank interest rates hike policy may be put on hold. 

“In such a recessionary economic environment, the ECB would probably normally stop hiking rates at an early stage or even start easing policy. However, the high level of inflation is expected to encourage the central bank to continue hiking until the end of the year, as it is committed to fight against any potential rises in longer-term inflation expectations,” wrote ABN-AMRO’s economists Schuiling and Kounis. 

“The risks to our forecast for ECB policy are skewed to more rate hikes in the 3-6 month horizon, given that the ECB's focus is currently on inflation rather than growth.”

For the ECB interest rate forecast, respondents in the ECB’s survey expected the central bank to steadily hike its main refinancing operations interest rate to 1.3% in the first quarter of 2023, from 0.5% in the third quarter of 2022. On an annual basis, ECB interest rate is expected to average at 1.5% in 2023 and 1.8% in 2024.

For the 2023 average, almost 90% of the respondents replied with values below 2%, and around 10% of respondents reported values above 2.5%. Similarly, 80% of respondents expected interest rates to be, on average, below 2% in 2024 and about 15% to be above 2.5%.

ING in its ECB interest rate predictions estimated the central bank to keep the key interest rate at 1% from the third quarter of this year until the final quarter of 2024.

The bottom line

ECB and analysts in this article expected interest rate hike to continue until the end of this year to fight for soaring inflation before resorting to smaller rate increases or completely halt rate hike. ABN-AMRO forecast the ECB to hike its interest rate by 50bp each in September, followed by a smaller increase of 25bp each in October and December 2022.  

ECB’s survey of 59 respondents projected the central bank to hike interest rates to average 1.5% in 2023 and 1.8% in 2024.

The analysts and respondents in ECB's survey did not offer ECB interest rate predictions after 2024 due to several variables involved that can influence indicators for ECB interest rate decisions, such as inflation, economic growth rate and unemployment. These variables are difficult to forecast as they depend on other factors such as energy and commodity prices and global economic growth.

Remember that analysts’ views can be wrong. Forecasts should not be used as a substitute for your own research. Always conduct your own due diligence before trading or investing. And never invest or trade money you cannot afford to lose.

FAQs

Further reading:

Euro forecast: Will EUR keep falling?

Forex market trends and forecasts in 5 charts: EUR/USD, GBP/USD, USD/JPY, USD/CHF and AUD/USD – August 2022 update