The ECB’s roadmap to normalization
The fallout from Thursday’s ECB meeting continues to haunt financial markets. Widening government bond yield spreads, markets aggressively pricing in two rate hikes this year, and tons of articles and opinions on what the ECB should or might do in the coming months. Let’s be clear, if the ECB had known what it wanted to do next, it would have said so last week. It is already decided that asset purchases will not stop and that there will be no rate hikes; we’re just waiting for that to be announced at the March meeting. Instead, the ECB last week simply marked a turning point. A turning point, opening the door to a faster reduction in asset purchases and the door to a rate hike this year. However, don’t expect the ECB to rush out. Here are some options for the ECB and a more detailed view of how we expect the ECB’s hawkish reversal to play out.
Lagarde tried to put the falcon genius back in the bottle at the EP
Just to sum up the most important elements of last week’s ECB meeting: the ECB no longer sees a rapid return of inflation to target; the phrase “risks to the outlook for inflation are on the upside” has been officially used again for the first time in almost 10 years, and ECB President Lagarde has refused to back up her statement earlier that an interest rate hike in 2022 was “highly unlikely”.
At today’s hearing in the European Parliament, Lagarde mostly repeated key messages from Thursday’s ECB meeting, but subtly pushed back on overly aggressive rate hike expectations. She stressed that any policy adjustment “will be very gradual” and that there was no sign that “inflation will be consistently and significantly above our medium-term objective, which would require measurable tightening.” Furthermore, she said that the ECB was determined to use all the necessary tools to ensure an equal transmission of its policy to all member states. While those comments leave some open questions, like how to combine the end of asset purchases with still-tight bond yield spreads, it’s clear that Lagarde’s mission today was to put the hawk genius back in the bottle. Normalization does not mean tightening.
Three steps on the ECB’s path to normality
To understand what the ECB will do and when, we need to distinguish three different stages on the road to policy normalization: tapering, an end to negative interest rates and finally a shift to a more neutral monetary policy. Each of these stages will have different discussions of inflation.
- Degressive. The Pandemic Emergency Purchase Program (PEPP) will end in March. This decision has already been taken at the December meeting. Inflation forecasts had returned more or less to pre-pandemic levels, meeting the PEPP target. The higher the ECB’s inflation forecast for 2022 and 2023, the lower the support for the continuation of the asset purchase program (APP). Recall that in December the ECB announced that it would use the APP to mitigate any impact on the market from the end of the PEPP by increasing asset purchases under the APP to €40bn. euros in the 2nd quarter, then lowering them to 30 billion euros in the 3rd quarter and 20 billion euros in October. . No end of the APP had been announced. There are several options to accelerate the end of QE: keep the APP at the current level of 20 billion euros, not allow a temporary increase, accept a potential cliff edge effect and end the APP by September 2022. One option more flexible could be to allow the APP to increase to 40 billion euros in 2Q but to end it by September 2022.
- The end of negative rates. Once the net asset purchases are complete, the next crisis tool will be discussed and likely returned to the toolbox. Returning the deposit rate to zero could bring relief to the banking sector and could be an adequate signal that the era of unconventional measures is over. Here, the same inflation considerations as in the tapering discussion will apply.
- Rise in interest rates above zero. The timing of rate hikes once the deposit rate has been reduced to zero is a completely different matter and will depend heavily on the ECB’s longer-term view of inflation, in particular its view of the issue of whether structural factors, such as the fight against climate change, demographic factors and de-globalization will drive up inflation. If so, the ECB has only two options: either accept somewhat higher inflation – as rate hikes will have a limited impact on inflation driven by global drivers, as rate cuts have had on deflation induced by global drivers – or embark on a series of rate hikes at the risk of stifling the recovery and discouraging the investments needed for the green transition.
Besides the discussion on the inflation outlook, the ECB is also expected to have a discussion on yield spreads. Does the ECB actively want to maintain narrow spreads to allow a smooth and homogeneous transmission of its monetary policy in the countries of the euro zone? Or will he accept broader returns and their potential implications for debt sustainability? And will the reinvestment of maturing bonds be enough to keep spreads at bay? To be clear, at current levels there is still plenty of room for yields to rise before they undermine debt sustainability. In addition, governments took advantage of the period of negative bond yields to refinance debt and extend duration.
What should the ECB decide?
The only thing the ECB will really have to decide at the March meeting is whether or not it wants to accelerate the asset purchase cuts. If this is the case, it will have to announce the changes made to the planned APP purchases. Otherwise, APP purchases could still end immediately after October.
As long as the ECB sticks to the principle of sequencing, i.e. no rate hikes before the end of net asset purchases, a rate hike will not be on the agenda of the meeting in March, nor that of June.
What will the ECB decide?
Barring a severe economic crash in the coming weeks, we expect the ECB’s inflation projections to be revised upwards again, setting the stage for a faster taper. We expect the ECB to stick to the initial increase in the APP to €40bn per month to smooth the end of the PEPP, but then to end the APP over the course of the third trimester. This opens the door for a rate hike in the fourth quarter. Remarkably, as Dutch central bank governor Klaas Knot’s comments yesterday illustrated, even hawks are refusing to call for a rate hike sooner. If, however, by the end of the third quarter, headline inflation begins to decline and/or U.S. rate hikes prove too aggressive, a rate hike could still occur in the first quarter of 2023. Shortly afterwards, the ECB could raise the deposit rate for the second time and technically raise the refi rate as well. With a zero deposit rate and a refi rate of 0.25%, the ECB will adopt a wait-and-see approach for the rest of 2023.
We often hear that the risk of such a scenario is an unjustified widening of bond yield spreads. The answer of a European technocrat would be that in such a scenario, the famous program of monetary transactions in securities (OMT) could be triggered. Yes, the tool to make everything operational. However, the UNWTO requires that a eurozone country first apply for a budget support program from the European Stability Mechanism, placing the country more or less under European surveillance. Politically always delicate. We expect the ECB to try to contain spreads by reinvesting maturing assets. Alternatively, the ECB could consider abandoning the principle of sequencing, managing a small asset purchase floor of around €20 billion per month (the monetary transmission mechanism harmonizing the asset purchase program ), while bringing the deposit rate to zero. However, while this option could work for the deposit rate zeroing phase, it would be counterproductive once the ECB decides to raise the refi rate further.
Overall, expect further attempts by ECB members in the coming weeks to steer and influence the political debate in both directions. This will be accompanied by volatility in the financial markets. In any case, we think the market speculation on ECB tapering and rate hikes is currently as overdone as it was underplayed just a week ago. Over the past 20 years, the ECB has been in little rush to radically change its position.
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