European Central Bank policymakers are meeting on Thursday amid exceptional turmoil in financial markets that could force it to ditch plans for another hefty interest rate hike as fears of a fresh financial crisis crowd out inflation worries.
Having raised interest rates since July at its fastest pace on record to curb inflation, the ECB had effectively promised another 50 basis point (bps) increase for Thursday and signaled further moves in the months ahead.
But the collapse last week of Silicon Valley Bank in the United States has raised concerns about stress across the banking sector and sent shares into a dive, with Credit Suisse, long dogged by problems, at the center of the rout in Europe.
While shares were rallying on Thursday after the Swiss National Bank threw Credit Suisse a $54 billion lifeline, the volatility kept markets under stress, a worry for the ECB since monetary policy works via the financial system.
This requires the ECB, the central bank for the 20 nations that share the euro, to reconcile its inflation-fighting mandate with the need to maintain financial stability in the face of overwhelmingly imported turmoil.
"The support provided by the Swiss National Bank to Credit Suisse removes systemic risk to the extent that the ECB will still be able to raise rates today by 50 bps," Lorne Baring, the Managing Director of B Capital SA said.
Supporting the case for a bigger rate move, the ECB's new economic projections will show inflation significantly above its 2 percent target in 2024 and slightly over in 2025, a source with direct knowledge told Reuters earlier.
Projections for underlying inflation, an indicator of the durability of price growth, are meanwhile set to be raised, suggesting that disinflation will be protracted and monetary policy will have to remain tight for some time.
This outlook is so worrying that prior to the turmoil in the banking sector, a long list of policymakers had advocated rate hikes continuing beyond March.
COLD FEET?
Markets are nevertheless doubting the ECB's resolve and have dialed back bets on the size of Thursday's move and subsequent rate hikes. Money market pricing suggests that investors now see a roughly 50 percent chance of a 50 bps increase, down from 100 percent last week but still above the 20 percent priced at one point on Wednesday.
The peak ECB rate, also known as terminal rate, is now seen at around 3.25 percent, down from 4.1 percent last week, an exceptional reversal in market pricing.
The banking stress is significant enough for the ECB to walk away from its own guidance and dial back tightening plans, some analysts argued.
"Current developments qualify as 'extreme', in our view, justifying a reassessment of our ECB call," Barclays economist Silvia Ardagna said. "We assign a 20 percent probability to no hike, a 60 percent probability to a 25 bps hike and a 20 percent probability to a 50 bps hike."
Even if the ECB goes ahead with the 50 bps hike, it is almost certain to move away from its recent practice of signaling its next step and will leave the door open regarding the May meeting, even if a bias for higher rates remains.
ECB President Christine Lagarde will almost certainly try to reassure investors about the health of the bloc's banks, arguing that they are better capitalized, more profitable and more liquid than during previous periods of turmoil.
But the ECB is likely to stop short of offering specific measures to help banks, especially since it has just removed a subsidy from a key liquidity facility in an attempt to wean lenders off central bank cash.
Lagarde could nevertheless signal that the ECB is ready to step in should contagion start impairing the health of euro zone lenders, and thus preventing the ECB's monetary policy from being deployed effectively.
"The ECB will be minded to stick to the separation principle: gearing the monetary policy stance towards achieving the inflation aim; and using other tools to deal with financial stability," BNP Paribas said. "Indeed, interest rates are probably the wrong tool to address a liquidity problem.