ECB Commits To Series Of Rate Hikes In Perilous Pivot

The ECB will end net asset purchases under its long-running QE program on July 1, the bank said Thursday, in a statement that could be construed as hawkish, despite disappointing out-of-consensus calls for a 50bps rate hike in July.

Principal payments from maturing bonds purchased under the program will be fully reinvested “for an extended period of time” following the onset of rate hikes. The forward guidance on reinvestments of APP assets remained open-ended. They’ll continue “for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance.”

Principal payments from assets purchased under the pandemic QE program, PEPP, will be reinvested “at least” through the end of 2024. When those assets begin to run off, PEPP QT will “be managed to avoid interference,” the ECB said.

The bank meant “interference” with monetary policy transmission, but that’s synonymous with markets in the eurozone. The ECB needs to guard against fragmentation risk during the normalization process by ensuring that any widening in periphery spreads remains orderly. Price discovery, yes. But gradual, carefully-managed (and thus oxymoronic) price discovery.

The statement reiterated that PEPP reinvestments are “flexible.” They can be “adjusted” across asset classes and, crucially, jurisdictions. Effectively, the pandemic QE program handed the ECB a tool to cap spreads. That’ll likely be its legacy. The reference to Greece remained in the policy statement, as did a nod to the possibility, however remote, that net purchases under PEPP could be revived in the event the pandemic were to reassert itself as a macro headwind.

For now, though, the macro headwind is obviously inflation, and the end of net purchases under APP paves the way for a rate hike next month. On the surface, the ECB’s policy stance is laughable. They’re running negative rates with headline inflation at 8% (figure below).

New staff projections released Thursday showed the ECB expects inflation to run at 6.8% in 2022, declining to around half that next year and to 2.1% in 2024.

“This means that headline inflation at the end of the projection horizon is projected to be slightly above the Governing Council’s target,” the statement said. The ECB sees core inflation averaging 3.3% this year, 2.8% in 2023 and 2.3% in 2024. All of those projections are higher than forecasts issued in March.

“These projections indicate that inflation will remain undesirably elevated for some time,” the bank gently noted, before striking a hopeful tone. “Moderating energy costs, the easing of supply disruptions related to the pandemic and the normalization of monetary policy are expected to lead to a decline in inflation,” the statement read.

The core forecasts may be feasible. The headline projections are just guesses. I’m quite sure ECB officials would admit as much off the record, and maybe even on the record at this point.

The Kremlin got the blame for last month’s scorching-hot headline print, illustrated poignantly in the figure (above). The ECB attributed the jump to surging energy and food prices, “including due to the impact of the war.”

New growth projections see the eurozone economy expanding 2.8% this year, 2.1% next and 2.1% in 2024. Those forecasts are higher than projections for the euroarea released by the OECD on Wednesday, particularly so for 2023.

Officials, including and especially Christine Lagarde, spent weeks laying the groundwork for a hike in July, with some arguing for a 50bps move. The ECB precommitted to a 25bps hike on Thursday, and opened the door to a larger move two months later, plainly a compromise between doves and hawks.

“The Governing Council undertook a careful review of the conditions which… should be satisfied before it starts raising the key ECB interest rates [and] concluded that those conditions have been satisfied,” the statement said, adding that the GC “intends to raise the key ECB interest rates by 25bps at its July monetary policy meeting.”

Notably, they precommitted to a hike in September too, and explicitly raised the prospect of a 50bps move at that meeting, calling the size of the expected hike dependent on the evolution of the medium-term inflation outlook. If that outlook shows price pressures are likely to “persist or deteriorate,” the ECB said “a larger increment will be appropriate at the September meeting.”

They went further. After September, and based on the current projections for inflation, officials anticipate raising rates in “a gradual but sustained” fashion.

To call this a watershed moment would be to understate the case. Prior the pandemic and the war, Europe had a date with Japan in deflationary limbo. Monetary policy reflected that. It’s a whole new world now, even as some worry officials are on the brink of committing a “classic” policy mistake (figure below, from BofA).

Plainly, a lot hinges on the conflict in Ukraine and the evolution of Europe’s fraught efforts to break its dependence on Russian energy.

If gas flows are cut off to Germany or Italy or any other major buyer, inflation could go even higher.

There’s still no resolution to the Russian blockade of Ukraine’s ports. Those obstructions are preventing the country’s grain from reaching food insecure locales, and driving up prices. Restrictions on fertilizer from Russia and Belarus are contributing to price increases. Europe won’t starve, of course, but stubbornly elevated prices for key foodstuffs will raise the risk of stagflation, especially if accompanied by additional energy shocks.

This is a lose-lose scenario for the ECB. All optimism aside, they’re hiking into a slowdown and the factors contributing to off-the-charts headline inflation are largely beyond their control. You could argue they’re condemning Europe to stagflation.

And yet, what choice do they have? If you’re a developed market central bank, and your mandate is price stability, inflation can’t be 8%. It just can’t. Even if you know your capacity to ameliorate the situation is severely limited due to the nature of the inflation shock, you have to try. And so, Lagarde will try.

The ECB was keen to castigate Vladimir Putin. “Russia’s unjustified aggression towards Ukraine continues to weigh on the economy in Europe and beyond,” the June statement said. “It is disrupting trade, leading to shortages of materials and is contributing to high energy and commodity prices, factors [that] will continue to weigh on confidence and dampen growth, especially in the near term.”