European Central Bank officials have rapidly coalesced around lift-off and the near-term monetary policy normalization path that we have been expecting for quite some time.
That consensus now lies squarely around a hard stop to the ECB’s Asset Purchase Program on July 1, followed rapidly by liftoff from the -0.50% deposit rate at the July 21 Monetary Policy Meeting. Barring any major shocks, that will most likely be followed by a 25-basis point hike at each of the ECB’s quarterly forecast round meetings on September 8 and December 15, to end the year at +0.25%.
With a bit of ground to potentially cover in raising rates, and monetary policy conditions that are clearly not in line with the ECB’s outlook, the Governing Council cannot be constrained by hiking only at quarterly forecast meetings, and officials say that every meeting should be considered live. That said, squeezing a fourth 2022 interest rate hike into the ECB’s October 27 policy meeting appears a lower than even probability as the Council feels its way into this cycle, at least as things currently stand.
Likewise, unlike the US Federal Reserve, the ECB base outlook and consensus still leans heavily towards 25 basis point increment moves, and not 50s. Nevertheless, hawkish president of the Dutch central bank Klaas Knot noted just today that 50 basis point moves should not be ruled out if inflation fails to top out as expected.
With the ECB on path to be still adding accommodation well into next year, we believe an argument could already be made that the conditions for a 50-basis point hike are in place. That said, we do not get a vote, and we think a move to 50s is unlikely, even if not impossible. We suspect, if needed, the easier path to consensus at the ECB would be to add that fourth rate hike in October.
Beyond consensus around ending the year at +0.25%, with a chance that could be +0.50%, the road is far less clear. Here, senior ECB officials still fall into two broad camps.
The Destination After Lift-Off
The first camp, embodied most clearly by Chief Economist Philip Lane, continues to point to the outsized effect of high energy costs on inflation. While acknowledging that current rates are not suitable for the eurozone, they feel that with high energy costs eating into consumption it will take no more than a modest and gradual “normalization” of policy rates to a still undetermined nominal neutral rate to bring inflation back to the ECB’s 2% target.
Banque de France Governor Francois Villeroy estimates that with a real neutral rate of most likely somewhere between -1 and 0%, and an inflation target of 2%, the nominal short-term neutral rate for the euro lies probably between 1% and 2%. The more dovish Lane, pegging the real rate at -1%, puts nominal neutral closer to 1%. Those views, roughly speaking, would translate into a cycle high most likely for rates on a 1% handle, call it around 1.5%.
The second camp is not so sure, with a growing number of ECB officials concerned over the strength, durability, and broadening of underlying inflationary pressures, even if these may be close to a peak.
Executive Board Member Isabel Schnabel, for example, argues that trimmed mean measures that strip out the most volatile components are a far more accurate reflection of core inflationary pressures than the traditional practice of stripping out energy and food, and these are uncomfortably high. Indeed, she argues, by these measures eurozone “core” inflation is not that dissimilar to core inflationary pressure in the United States.
That in turn is exacerbated by a rise in inflationary expectations that while initially welcomed, is already well above 2% on a median basis, and increasingly skewed to a higher right tail on distribution risks.
Schnabel points also to the global and coincident nature of massive imbalances both on the supply and demand side, and to historically tight European labor markets and still strong consumer spending power, even with higher energy costs. That, if anything, allows firms to continue to pass higher input costs onto the consumer, whose real wages are being eroded by inflation, even if rising on a nominal basis.
More Clarity by Year-end
Having won the fight to get on with the normalization process, these hawks feel the picture will be clearer by the end of the year on global inflationary pressures, energy, consumption, and on the effectiveness of the US Federal Reserve’s efforts to mop up the largest source of excess demand on the globe.
Until then, whether a modest “normalization” of rates that the doves assume will be enough to bring the ECB back to its 2% target, or whether it will require a more restrictive stance, is far from obvious to these Governing Council members. Indeed, some note that the ECB’s entire Strategic Review, and many of its models, are predicated on an assumption the ECB would always be struggling to push inflation up from below, in a disinflationary world.
Speculation over BTPs and Fragmentation
In the meantime, as the ECB pulls back on its years of ultra-accommodative monetary policy, yields on European Government Bonds have been rapidly climbing. German 10-year bunds have risen by roughly about 150 basis points from recent lows of around -0.5%, to 1%, while Italian bonds have risen by roughly 250 basis points, from around 0.5% to just under 3%.
That move in Italian BTPS seems to have generated a certain amount of angst in the press and markets and has led to a good deal of speculation over emergency facilities the ECB may be secretly devising behind the scenes to address this widening in spreads.
That speculation appears, as we have written numerous times, to be rather wide of the mark.
While the European Central Bank will always be alert to the risk of excessive “fragmentation” across eurozone economies and jurisdictions, and will stand ready to act if needed, these moves are largely seen to be orderly, fundamentally justifiable, and totally predictable in a rising rate environment, even if rapid for sure.
To put the moves in context, one ECB official notes, BTPs traded in the recent past at spreads of 250 basis points over German bunds, and that spread was off a lower bund base rate of around 0%, as opposed to the current 1%, meaning it was that much wider then on a proportional basis.
As to absolute levels, German bund yields could well go to 2% and still be comfortably consistent with recent historic parameters.
New Facility Unlikely
Indeed, in response to all the speculation, ECB officials we have canvassed all point to the challenges in devising a new program to address fragmentation when there is no crisis at hand, and when there is no consensus or frankly reason to define in advance a parameter under which such a program should be activated.
As things stand, the ECB has indicated it can and would actively manage the reinvestment of bonds in its Pandemic Emergency Purchase Program portfolio to address localized strains in the sovereign debt markets, should the need arise.
Markets are quick to dismiss this as lacking firepower, but ECB officials note that the central bank has by now solid credibility and a strong track record in its ability to fight fragmentation when needed. As case in point, they point to how little the ECB had to redirect when push came to shove from core to peripheral markets and away from its self-imposed Capital Key guidelines once it announced in March of 2020 the PEPP facility to fight excessive fragmentation.
Villeroy has also floated the idea of reactivating the ECB’s LTRO bank lending program to replace the expiring TLTROs that have been benchmarked to the bank’s negative deposit rate. ECB officials have always understood that these low interest loans to the banking sector, intended to encourage lending into the real economy, could be used to purchase sovereign bonds as well.
The suggestion to reactivate an LTRO program, however, does not appear to have broad based support around the Governing Council as it embarks on a hiking cycle. Indeed, perpetuating an old ECB “separation” policy of favorable rates for the banking sector is seen by many to have worked against the central bank’s long-term objective of rationalizing the European banking sector
That said, even if its architecture is incomplete, the ECB and European fiscal authorities do have other options in addition to reinvestments to stabilize markets, should these be needed. That includes 200 billion euros or so of funds that have already been allocated by fiscal authorities, but which are still left untapped in its Next Generation EU fund.