ECB likely to stick to big rate hike despite banking turmoil

© Reuters. FILE PHOTO: The logo of the European Central Bank (ECB) is pictured outside its headquarters in Frankfurt, Germany, April 26, 2018. REUTERS/Kai Pfaffenbach

By Francesco Canepa and Balazs Koranyi

FRANKFURT (Reuters) -European Central Bank policymakers are leaning towards a half-percentage-point rate hike on Thursday, as the banking sector turmoil is dissipating, the euro zone economy is picking up strength and inflation is set to remain too high for years.

Investors had begun to doubt the ECB's commitment to another big rate hike this week after the collapse of Silicon Valley Bank (SVB) in the U.S. sent ripples through global financial markets.

But a source close to the ECB's rate-setting Governing Council said there was no fundamental change in the outlook, so ditching a widely repeated commitment for a 50 basis point rate increase on Thursday would damage credibility.

Underlying this view, fresh figures on Wednesday showed that the euro zone's vast industrial sector expanded much faster than expected in January while Germany, the bloc's biggest economy, was also picking up strength.

Futures on German government bonds, the euro zone's benchmark fell after the Reuters report and ECB rate expectation rose, reversing course after the unusual volatility induced by SVB's collapse.

An ECB spokesperson declined to comment.

Although the market turmoil could make the ECB more cautious in outlining future rate hikes, its main problem, that inflation is far to high, has not changed.

The source said that the ECB's new projections for the years ahead will be lower than in December but they still put price growth well above the central bank's 2% target in 2024 and slightly above it in 2025.

Furthermore, forecasts for core inflation, which excludes food and energy prices, were set to be revised higher, emboldening calls for more rate hikes by policy hawks on the ECB's Governing Council, the source added.

Much of the inflation outlook hinges on wage growth, which is still catching up after rapid inflation, but the 5% to 6% expansion expected this year is inconsistent with 2% inflation so moderation will be needed.

That might come as falling headline inflation helps people recover some of their purchasing power.

"Slowly falling inflation rates and rising wages should lead to real wage growth again from mid-year at the latest and support the domestic economy," Germany's Ifo Institute said.

Still, dovish policymakers who have been preaching greater caution in raising borrowing costs and warning about the risk of financial instability felt vindicated by the recent market turbulence, the source said.

They were likely to push back against committing to further rate increases and say instead that any new move would depend on incoming data.

The ECB can push through decisions with a simple majority though President Lagarde has been known to seek the broadest possible consensus.

Money markets were pricing in an 85% chance of the ECB raising its deposit rate by 50 basis points to 3.0% on Thursday, with some banks including Deutsche Bank (ETR:DBKGn) expecting a smaller or no increase.

Investors have sharply cut their bets on further rate rises since the SVB collapse, with the deposit rate now seen peaking at 3.65% in the autumn, compared with an outlook last week of more than 4%.

Euro zone supervisors see limited consequences for banks in the region from the collapse of SVB and two other lenders, while stressing the need to watch any further spillover closely.

SVB became the biggest U.S. bank to fail since the 2008 financial crisis after its outsized bets on U.S. government bonds and mortgage-backed securities went sour as a result of rising interest rates.

Its collapse forced U.S. authorities to spring into action at the weekend. After an initial rout on Monday, markets have become calmer amid hopes a wider financial crisis would be averted.