European flags are seen in front of the ECB building, in Frankfurt
Signage is seen outside the European Central Bank (ECB) building, in Frankfurt, Germany, July 21, 2022. Reuters

Goldman Sachs, Morgan Stanley and at least two other banks expect the European Central Bank to deliver a smaller quarter-point hike in May, as it grapples with stress in the banking sector and high core inflation.

Goldman's terminal rate forecast for the ECB now stands at 3.5%, down from 3.75% expected previously when it forecasted a 50-bps raise in May. For Morgan Stanley, a smaller May hike expectation leaves the peak rate forecast at 3.75% by July, down from 4% expected earlier.

The changes in forecast follow the ECB's decision on Thursday to press ahead with a 50-bps hike in its deposit facility rate, taking it to 3%. Some rate-setters had called for a smaller raise amid uncertainty in the banking sector.

The collapse of U.S. mid-size banks Silicon Valley Bank and Signature Bank, and worries about the future of First Republic Bank and larger Swiss lender Credit Suisse, have prompted bets that central banks could temper or even pause interest rate hikes as they scramble to contain the contagion.

"We believe that further rate hikes (by the ECB) are likely despite the financial market volatility because the risk of severe banking sector contagion still looks limited and core inflation is likely to remain strong in coming months," Goldman Sachs economists, led by Sven Jari Stehn, said in a note dated March 16.

HSBC says it has retained its ECB terminal rate forecast at 3.5%, but now expects the central bank to deliver two smaller 25-bps hikes in May and June, as opposed to a 50-bps hike in May it expected earlier. Barclays holds the same view.

Traders see the ECB rate peaking at around 3.23% by September or October.

Meanwhile, J.P.Morgan, Deutsche Bank and Swedish Bank SEB expect the ECB to deliver a 50-bps hike in May, but warned of downside risks to their forecasts given current market volatility and inflation remaining well above the central bank's target.

The ECB cut its inflation projections on Thursday to 5.3% for 2023, still well-above above its 2% target.

Goldman Sachs European Central Bank