ECB: Rate Hike Optionality

Published on November 22, 2021
SGH Insight
European Central Bank officials, concerned by the notion that markets may start pricing “premature” rate hikes some twelve months into the future, have pushed back on expectations of a fourth quarter 2022 liftoff from the current negative 0.5% benchmark deposit rate.
*** But even as they insist that this pricing does not conform to the ECB’s own reaction function and forecasts, our understanding is that there is a strong likelihood the ECB will seek to build some optionality into the revised Asset Purchase Program at its upcoming Governing Council meeting on December 16 to allow for a more rapid run-off of the bond purchasing program should inflationary pressures persist.
Market Validation
Bloomberg 11/23/21

The European Central Bank’s markets chief
and the Dutch National Bank governor urged an end to emergency
stimulus, highlighting inflation risks while insisting the
recovery can weather new pandemic restrictions.
Executive Board member Isabel Schnabel and Governing
Council member Klaas Knot both suggested increasing vigilance to
the threat of surging prices, just weeks before a crucial
decision on the future of asset purchases.
“The risks to inflation are skewed to the upside,” Schnabel
said in an interview. That was the most hawkish comment yet from
one of institution’s top team of six officials before the
December meeting, prompting investors to resume bets on an
interest-rate hike next year. The plan to terminate emergency
bond buying in March is “still valid,” she added.

European Central Bank officials, concerned by the notion that markets may start pricing “premature” rate hikes some twelve months into the future, have pushed back on expectations of a fourth quarter 2022 liftoff from the current negative 0.5% benchmark deposit rate.

*** But even as they insist that this pricing does not conform to the ECB’s own reaction function and forecasts, our understanding is that there is a strong likelihood the ECB will seek to build some optionality into the revised Asset Purchase Program at its upcoming Governing Council meeting on December 16 to allow for a more rapid run-off of the bond purchasing program should inflationary pressures persist.

*** That may entail a decision at that meeting to build in quarterly reviews of the pace of APP purchases once it is topped up from the current 20 billion euro per month pace to compensate for the expiration of the Pandemic Emergency Purchase Program in April of 2022. A quarterly review was built into the emergency PEPP program as well, and it is seen to have served its function there well.

Debate over Medium Term Forecasts

The need to build optionality in this next, and presumably final, leg of the ECB bond purchase program is predicated on the central bank’s commitment to sequencing lift-off on interest rates only after the completion of its asset programs.

And while the ECB is united (sort of), in pushing back on late 2022 rate hikes, there is a very broad and tacit understanding that these hikes could very well come soon after, in 2023, with considerably less certainty than is projected by the ECB leadership over its medium-term inflation forecasts.

Chief Economist Philip Lane, and ECB President Christine Lagarde, continue to emphasize that judging from where the ECB sits now, the medium term forecast is still for inflation to drop back below its 2% target level after spiking sharply higher this year, due to an essentially mean-reversion assumption that energy prices will fall back down, faith that supply constraints will ease in the fullness of time, and a technical drop off in the German VAT tax effect come January 2022.

In making the case for continued aggressive stimulus, ECB President Christine Lagarde, while acknowledging that prospects for medium term inflation have improved, even went so far as to emphasize in a November 15 speech that by the fourth quarter of 2022, Eurozone inflation could be back down at 1%.

That forecast, however, is due to a year-on-year base effect comparison to the massive spike in inflation now, in the fourth quarter of 2021, and does not reflect any certitude on the far more germane, and unknown, questions over the potential broadening of underlying inflationary pressures and expectations.

In a direct rebuttal to both Lane and Lagarde, Bundesbank President Jens Weidmann warned one week later that “the fallout from the pandemic could have a marked impact on the inflation setting. And it could well be that inflation rates will not fall below our target over the medium term, as previously forecast.”

Policy Implications

For policy purposes, the key point is a concern that the gap between the hawkish and dovish views is in fact not that large.

As stated by ECB Governing Council Member and Belgian National Bank Governor Pierre Wunsch, while the 2023 staff forecast is likely to remain below 2%, “it wouldn’t take much for realized inflation in 2023 to be at 2% — one or two surprises or some second-round effects, so just a fraction of everything we’ve seen in the last three months.”

These differences in forecasts will clearly not be resolved over the next days or even weeks, but the ECB will need to build optionality and policy flexibility for the upside as it gauges the momentum behind underlying inflation impulses going into 2022, including when it rolls out the new “modalities” on December 16 for the 2022 Asset Purchase Program.

This was hinted at in a November 17 speech by Board Member Isabel Schnabel that was highlighted to us by ECB officials as marking an important pivot (see SGH 11/12/21; “ECB: A Key Messaging Pivot”):

On the one hand, this means avoiding the mistake of a premature tightening of monetary policy in response to a temporary and possibly short-lived inflation spike. On the other hand, it means keeping a watchful eye on the upside risks to inflation that financial markets currently anticipate and retain optionality to be able to act if needed, so as to maintain trust in our determination to defend price stability in a symmetric way and prevent a deanchoring of inflation expectations in both directions.

Our understanding is that this need for upside optionality will play heavily in the debate on December 16 over the structure of the new Asset Purchase Program.

 

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