Klaas Knot’s “double down” on rates


My expectation for the council meeting on 16th March in the European Central Bank (ECB) is clear that the central bank will raise interest rates by 50 basis points, but it will not be a surprise either. If one listens to the statements of various members of the Governing Council, as well as the guidance to the financial market that ECB President Lagarde has given, then an interest rate increase should be expected among most investors. The interesting question is what the ECB chooses to do in the following months.

In the search for insight to answer this question, the press conference will be very interesting, and the ECB will probably consider its words very carefully. I expect the ECB to reiterate that they will fight inflation and take more steps if necessary. If the central bank does not ensure this, then many market participants will view the ECB as weak, and there is no reason to believe that this will happen.

However, it will also surprise me very much if the ECB directly announces that it will continue at the same pace at the next planned monetary policy meeting, which is on 4th May. In my view, the most likely outcome of the press conference on 16th March is that it leaves the financial markets in a kind of indecisive no man’s land. Probably with an indication that the arrow is still pointing up for the interest rate direction at the ECB, but no more than that either.

A split council

I am often critical in my assessment of the ECB, but this time it is not my intention to give the impression of a hesitant central bank, but there will be two good reasons why the ECB is very balanced in its statements. The first reason is that there is quite a long time until the next monetary policy meeting in May. Therefore, it is natural to use the timeframe to observe whether the previous interest rate increases have had any effect on the economy.

The second reason is one that I consider to be political. The majority of the ECB’s governing council are still so-called “doves”, which means that they prefer an interest rate level on the low side and a monetary policy that is not too tight. An excellent example is from 8th March when the head of the Italian central bank, Ignazio Visco, issued a warning, and he also has a vote when the ECB rate is set.

Ignazio Visco sent a direct warning to the “hawks” in the governing council who argue for a tight monetary policy. It is in line with Italian members of parliament who, since the fourth quarter of last year, have been dissatisfied with the ECB’s interest rate increases.

Many economists, and participants in the financial market in general, will probably find it irresponsible if the ECB does not raise interest rates further. But the worst thing that could happen to the ECB’s credibility is if the majority in the ECB governing council decides not to let themselves be dominated by the hawks, and thus, decide not to raise interest rates.

I think the risk of such a “palace revolution” is very low right now, but the fact that the decision-makers in the governing council express themselves so divergently is remarkable. This shows that there is a growing disagreement internally among the decision-makers. Therefore, it is probably fine to have a sort of break for political reasons, and I estimate that this is also a reason why the statements on 16th March will be very balanced.

Doubling interest rates

There has been very strong marking at the top ECB level for a long time, and it is in full public view, which is worth noticing. There is no doubt that the “hawks” in the ECB have felt held down for a long time, particularly Germany and the Netherlands. Since the middle of last year, the two leading countries have regained monetary freedom by once again talking about interest rate increases.

Klaas Knot's double down on rates - Graph 1

The Dutch central bank chief, Klaas Knot, was very specific in an interview in the Financial Times on 26th December last year when the ECB, as a Christmas gift to investors, previously raised interest rates on 21st December. In the interview, Knot said that the ECB had just moved into the second half of the interest rate cycle and that he could see it peaking this summer (this year).

Any prediction can be adjusted over time according to developments, but it looks like a doubling of the interest rate as it was on 21st December – that it is very close to 5 percent for lending at the ECB (graph one), and thus 4.50 percent for deposits. I can safely say that it is above the current market expectations, and will probably disturb the European stock markets if the development goes that far. But what I give even more focus on is whether the yield curve will continue to invert. Will it become even steeper with the high end of the curve in the one- to two-year maturity (graph two)?

Klaas Knot's double down on rates - Graph 2

It expresses that investors believe inflation will, at some point, fall sharply, and an inverse yield curve usually expresses a market expectation of a coming recession. It will probably come, but regardless, I would put my money on Knot’s “double down” on interest rates, as the most likely scenario for the next 3 to 4 months.

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