Inflationary pressures remain elevated and the Governing Council (GC) aims to bring its policy rates into neutral territory quickly. We believe the European Central Bank (ECB) will hike policy rates another 75 basis points at its October meeting. We expect an additional 50 basis point hike in December, which would bring the policy rate to 2% and towards the upper end of most estimates of a neutral policy rate configuration for the Euro area. We think the GC will make clear that a neutral policy setting might not be appropriate in all conditions, and expect a transition towards moving in 25 basis point increments next year, as the hiking cycle pivots from policy normalisation to policy tightening.
The ECB puts the fight against inflation ahead of growth concerns, the macroeconomic configuration remains complex and political risks elevated.
Additional thoughts:
Interest rates: The market is pricing 140 basis point of rate hikes by the end of this year, and another 100 basis points over H1 next year. There remains considerable uncertainty where a neutral policy rate for the Euro area might be, but anything between 1.25% and 2.0% in nominal terms seems plausible. Current market pricing hence suggests somewhat restrictive territory for the ECB, with a peak policy rate of 3.15% around the middle of next year. The terminal rate priced in the market looks reasonable given current information, the large uncertainty around inflation dynamics and relative to other major developed market jurisdictions, such as the UK or US. While both previous rate hikes of 50 and 75 basis points have been characterized as frontloading without changing the assessment of the terminal rate in the hiking cycle, we think the GC will make clear that a neutral policy setting might not be appropriate in all conditions, particularly if faced with high spot inflation threatening to de-anchor medium-term inflation expectations or the impact of the war and the pandemic on the productive capacity of the economy turning out to be bigger and longer-lasting than expected. While the ECB will not release new staff macroeconomic projections in October, Vice-President de Guindos commented recently that what the ECB considered as downside scenario in September is coming closer to the baseline scenario. Under the downside scenario from the September projections, the Euro area economy would shrink by 0.9% in 2023, while the baseline scenario envisages GDP growth of 0.9%. More importantly, projected inflation is higher under the downside scenario, with annual headline inflation expected to decline from an average rate of 8.4% this year to 6.9% in 2023, instead of from 8.1% this year to 5.5% in 2023 under the baseline scenario. After another 50 basis point hike in December, we believe the ECB will likely transition towards moving in more conventional 25 basis point increments next year, as the hiking cycle pivots from policy normalisation to policy tightening and inflationary pressures are expected to gradually subside. Eurozone headline inflation is expected to peak at around current levels towards the end of this year and decline fairly consistently throughout next year.
Quantitative tightening: As concerns the pandemic emergency purchase programme (PEPP), the GC currently intends to reinvest principal payments from maturing securities until at least the end of 2024. Regarding the standard asset purchase program (APP), the GC currently intends to reinvest principal payments from maturing securities for an extended period of time past the date when it starts raising the key ECB interest rates. Passively ending reinvestments would drain liquidity without adding collateral to the system, while actively selling bonds would swap reserves against collateral, a move that would make high quality bonds available and contribute to a reduction in collateral scarcity. While we do not expect the ECB to actively sell down government bond holdings anytime soon, we expect more discussion and communication regarding the size of the ECB balance sheet at the upcoming policy meetings, as the ECB approaches a broadly neutral setting on policy rates. We believe a decision around APP reinvestments will be made reasonably soon, potentially as early as at the December meeting, also in light of advanced Fed and Bank of England (BoE) balance sheet reduction strategies. APP redemptions of public sector holdings are estimated to average around €22bln per month from September 2022 until September 2023. In our baseline, we expect some form of passive APP run-off starting Q1 next year, implying an annual unwind of around €250bln of public sector securities in case of a hard stop to APP reinvestments. Relatedly, a run-off of the targeted longer-term refinancing operations (TLTRO) would see the ECB balance sheet shrink by around 24% until the end of 2024.
TLTROs, reserve remuneration and additional facilities: At its July policy meeting, the ECB stated that “in the context of its policy normalization, the Governing Council will evaluate options for remunerating excess liquidity holdings“. President Lagarde referred to the part of the statement on remuneration of reserves when she answered a question about possible changes in the TLTRO rates during the Q&A, which suggests that the ECB contemplates offsetting the benefit to banks from favourable TLTRO terms via a reduction in the average reserve remuneration. Given the rate applied to TLTRO borrowing post June 2022 features the average deposit facility rate during the entire life of the operation, banks still have a carry incentive to maintain their TLTRO liquidity as the borrowing rate would be lower than the rate applied to central banks deposits during rate hikes. Details have been missing since, and in September the ECB left TLTRO terms unchanged and decided to remunerate all excess reserves at the deposit facility rate. While we believe the most straightforward approach would be to change the TLTRO terms, the ECB might instead decide to remunerate most bank reserves at the deposit facility rate except part of reserves related to TLTRO borrowings. Both options aim to create incentives for banks to early repay part of their TLTRO borrowings, particularly money taken purely for arbitrage. Repayments of money taken for arbitrage should have little implications for markets, as these funds have been sitting idle at the various national central banks and never circulated in money markets. Another market neutral option to reduce payments to banks would be for the ECB to increase minimum reserve requirements and remunerate those at 0% instead of paying the main refinancing operations (MRO) rate. Normalizing policy rates in a context of €4.7trn excess liquidity and collateral scarcity risks further impairing the monetary policy transmission, hence we expect the ECB to explore options to better control money market rates. While we do not believe an announcement to be imminent, medium term options include a new secured or unsecured vehicle available to market participants without access to the ECB’s deposit facility, or large scale issuance of short term ECB debt certificates. While issued to banks, ECB debt certificates are eligible for trading in secondary market where they could be acquired by non-banks. Sizeable issuance of ECB debt certificates would increase the amount of high-quality collateral in the system and should be accepted by all lenders of bonds, including the German Bundesbank at its securities lending operations.
