UBS On-Air: Paul Donovan Daily Audio 'How bad is the ECB error?'
The ECB is poised to make a significant policy mistake by raising interest rates, a move that Paul Donovan from UBS argues will not address the underlying inflation issues in the Eurozone. Per the full note, this hike is seen as 'gesture economics,' primarily backward-looking and likely to increase economic fragility without effectively countering inflation or affecting consumer behavior. Meanwhile, the consensus target for EUR/USD is 1.075, reflecting a view that underscores the complexities in the region's economic environment as traders prepare for potential fallout from this monetary decision.
What the desk is arguing
The ECB's anticipated interest rate hike is viewed as a critical misstep, expected to inadvertently increase economic fragility rather than combat inflation. According to Donovan, raising rates merely reflects a '2022 mindset' and fails to acknowledge the current dynamics influencing consumer behavior, including rising energy costs.
Supporting this view, Donovan emphasizes that the expected quarter-point increase is unlikely to lead to a drastic reduction in consumer spending or savings rates. Instead, it may exacerbate the economic instability by transferring wealth from borrowers to savers, amplifying existing vulnerabilities.
Although raising rates may be seen as a corrective measure, it is likely counterproductive, as it fails to address the sources of inflation or improve broader economic confidence. The ECB's current strategy seems stuck, creating an environment ripe for further policy blunders.
Where it sits in our coverage
Our consensus target for EUR/USD stands at 1.075 with a range of 1.04 to 1.12. The current projections from jpmorgan target 1.10 for Mar-26, while bofa holds a contrary stance with a target of 1.04 for the same tenor.
This perspective aligns with the concerns raised by Donovan, suggesting that the market is bracing for the repercussions of ECB policy on currency positions, especially at the lower end of the projected range.
How other firms see it
Firms like jpmorgan and others appear aligned with Donovan's view of cautious sentiment on the ECB's policy direction. Conversely, bofa argues for a more bearish outlook, supporting their lower target amid ongoing uncertainties.
Traders should also monitor the interaction between the EUR/USD and broader economic indicators, particularly those that reflect energy prices and consumer spending patterns, as these elements are poised to affect the Eurozone's inflation trajectory significantly.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01The ECB's likely rate hike is deemed a policy mistake by UBS, ineffective against current inflation.
- 02Donovan warns this move could heighten economic fragility without addressing consumer spending patterns.
- 03Consensus EUR/USD target is 1.075, reflecting a cautious market outlook.
- 04Increased disparities between market forecasts highlight the elevated risks of ECB decisions.
Market implications
Traders should keep an eye on EUR/USD levels around 1.075 for signs of market reaction to ECB policy shifts. Additionally, the potential impact of rising energy prices on consumer behavior may provide more clarity on the currency's trajectory.
Risks to this view
Any major shift in inflation data or energy prices could invalidate this call, especially if they lead to a recalibration of ECB strategies or market expectations. A sudden change in consumer behavior or market sentiment could also force a reassessment of the current forecasts.
Good morning, this is Paul Donovan, Chief Economist at UBS Global Wealth Management. It's 6.30 in the morning London time on Thursday the 11th of June. Just how bad will the ECB's policy error be today?
That the ECB will make a mistake and raise interest rates does seem to be, sadly, almost inevitable. This is gesture economics at its worst. The interest rate increase will not impact inflation and it will not impact inflation expectations.
Inflation expectations don't matter very much at the moment anyway, because there are no signs of second round inflation effects. This is backwards looking policy making, pure and simple. The ECB is worried that inflation rose in 2022, so they are raising rates now.
Inflationary policy does not correct past errors like that, it only creates new ones. However, a quarter point increase in rates is not going to bring European growth crashing down. Any company that cannot withstand a quarter point rate increase at this particular point on the cycle would be being so badly run as to fail anyway.
Consumers will still spend and they will still cut back on their savings rates in order to cover the costs arising from higher energy prices. Raising rates is not going to suddenly increase the appeal of saving. What the rate increase does, by transferring money from borrowers to savers, is increase fragility in the European economy.
So today's error is an unenforced error. It's unnecessary, it's harmful, but it's not seriously harmful. US President Trump takes a very different approach to inflation to that adopted by what might be considered the Bundesbank faction of the ECB.
Trump declared yesterday, quote, I love the inflation. This is just as well as there's quite a lot of it happening in the United States at the moment. The rationale is that the inflation rate will fall by more when the war is over.
This is true as far as the change, though not the price level, is concerned. But the challenging aspect is that higher inflation today is reducing living standards in a way that lower inflation tomorrow is unlikely to repair very quickly. Average hourly earnings are not the same thing as wages and they are very different from income.
But the real inflation-adjusted average hourly earnings in the States today have fallen back to the level that they were at when Trump took office. The failure to improve real earnings is something people are conscious of. The detail of the inflation data did show an absence of second-round inflation effects.
And as expected, last year's tariffs are fading from the inflation data, though there's not much evidence that consumers are seeing lower prices from the reversal of tariffs. Overall, however, this data, alongside the employment data, does not give the US Federal Reserve an urgent need to cut rates. Next year, no doubt, but not for now.
The inflation data continues with US producer price inflation for May due for release today. This has some bearing on the calculation of the personal consumer expenditure deflator, which is what the Fed focuses on, though Fed Chair Walsh seems keen to focus on whatever inflation indicator is reporting the lowest number, rather than necessarily focusing on the indicator that best reflects the inflation experience of US households. There will be less excitement about today's data.
But as with the consumer, the pass-through of energy prices is likely to be relatively swift on this occasion. As far as energy prices go, the rather visible rate of firing in the middle of a supposed ceasefire in the Gulf is not something that is perhaps surprising investors. Claims of ships being escorted through the Strait of Hormuz are not being given too much credibility either.
It does seem to be the case that a small number of ships are travelling out of the Gulf, some with Iranian permission, having paid the necessary tolls, some perhaps not. But compared to pre-war levels, the volume of shipping is tiny and counts as little more than a statistical rounding error. Markets are only likely to change their views about navigation through the Strait if Iran signals it is letting more vessels past.
That's all for today. Have a good day. and a member of FINRA SIPC. The investment views have been prepared in accordance with legal requirements designed to promote the independence of investment research.
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