Pausing Is Not on the ECB’s Agenda as Inflation Concerns Persist

In the wake of the European Central Bank’s (ECB) latest rate increase, we retain our view that a 3.5%-4% terminal policy rate looks reasonable (see our latest Cyclical Outlook, “Fractured Markets, Strong Bonds”). The scope of additional ECB hikes will depend on the evolution of inflation and financial stability risks, which we believe are skewed toward a somewhat higher endpoint and the ECB remaining at the terminal rate for longer. Labour markets in Europe are exceptionally tight, wages are still catching up with prices, and the economy has been surprisingly resilient in the face of a severe energy shock as government policies have successfully shielded the economy.

The ECB raised its deposit facility rate by 25 basis points (bps) to 3.25% at the May meeting, bringing its policy rate even further into restrictive territory, following the 50-bp rate rise in March. While the ECB has returned to moving in more traditional 25-bp increments – and refrained from communicating unconditional expectations for the future interest rate path – it also made clear that it expects to raise rates further.

The ECB aims to bring policy rates to levels sufficiently restrictive to achieve a timely return of inflation to the central bank’s 2% target. Absent an unwarranted deterioration of financial conditions, the ECB is likely to keep on with raising rates, as the inflation outlook continues to be “too high for too long.” Indeed, Euro area headline inflation for April is expected to settle at 7% year over year, suggesting the ECB cannot consider it mission accomplished at the current juncture.

The underlying economic resilience of the Euro area remains a mixed blessing for the ECB. For inflation to fully normalize back to the 2% target, we continue to believe some cooling in the economy and in the labor market is needed.

While the near-term direction of travel on European duration is less certain, we believe European interest rate swaps should outperform core government bonds over time. The communicated end to asset purchase programme (APP) reinvestments from July onwards weakens the relative technical picture for government bonds.

The terminal rate: risks are skewed to a higher endpoint

The ECB reiterated that there is no forward guidance on interest rates anymore, and that it remains firmly in a data-dependent, meeting-by-meeting approach. Nevertheless, it also made clear that it is not pausing, and there is more ground to cover on interest rates.

While Euro area core inflation in April is projected by Eurostat to have fallen for the first time in 15 months (by -0.1% to 5.6% year over year), the sequential pace of core inflation in the Eurostat estimate accelerated to 0.6% month over month, as service sector prices jumped 0.8%. Meanwhile, the Euro area unemployment rate hit another record low of 6.5% in March, and recent public sector wage agreements in Germany could likely settle around 6% on average over the next two years. As a result, underlying inflationary pressure remains too high for comfort for the ECB.

Similarly, while the March money supply data and first-quarter 2023 bank lending survey point to weaker loan demand and tighter lending conditions (on the back of the ECB rapidly tightening monetary policy), these data points do alleviate fears of the recent banking stress morphing into a full-blown credit crunch. According to the survey, the main drivers of credit supply tightening were higher perceptions of risk and, to a lesser extent, banks’ lower risk tolerance.

The ECB is determined to ensure a timely return of inflation to its 2% medium-term target. Unless financial stability concerns come to dominate the economic configuration and impact the broader macroeconomic landscape to an unwarranted extent, another 25-bp rate hike at the June meeting seems a plausible baseline scenario. The new staff macroeconomic projections available in June will help inform the monetary policy stance over the following months.

The balance sheet: a step-up in tightening

As we expected, the ECB decided to reduce APP reinvestments from the current €15 billion monthly pace and cease them altogether in July, while continuing pandemic emergency purchase programme (PEPP) reinvestments in full. Ending APP reinvestments implies a quantitative tightening (QT) step-up from the current €15 billion per month, to around €25 billion per month on average over the second half of 2023.

Flexible PEPP reinvestments remain the first line of defense on the anti-fragmentation front, and we believe the ECB has little appetite for activating the Transmission Protection Instrument (TPI) or Outright Monetary Transactions (OMTs). The ECB currently intends to reinvest PEPP maturities until at least the end of 2024. While we do not rule out the ECB aiming for an earlier cutback in PEPP reinvestments at some stage, we would expect more progress on the reduction of the APP portfolio and greater visibility on the terminal policy rate to constitute necessary conditions for a departure from the current PEPP reinvestment guidance.

We do not anticipate the ECB to categorically rule out selling bond holdings, but envision a continued focus on a gradual and orderly passive reduction of reinvestments. As a result, the QT impact on the size of the ECB’s €7.7 trillion balance sheet and on the €4 trillion excess liquidity will be modest in the near term, with the main effect being considerably higher bond issuance to the market. Over the longer run, ECB reinvestment policy will also be influenced by the shape of a new operational framework for steering short-term interest rates, including the size of a structural bond portfolio.