ECB rate rises are about to get real. Says the ECB.
The Governing Council of the ECB decided on December 15, 2022, to raise the three key ECB interest rates by 50 basis points and expect to raise such rates further based on a substantial upward revision of the inflation outlook.
Following its decision, the ECB increased the interest rate on the main refinancing operations, the interest rates on the marginal lending facility and the deposit facility to 2.50%, 2.75% and 2.00% respectively, effective from December 21, 2022.
The hawkish press release issued by the ECB stressed that the following:
In particular, the Governing Council judges that interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-target.
Klaas Knot, Dutch central bank governor and one of the hawks on the Governing Council, recently stated that the central bank was only just beginning the “second half” of its rate-increasing cycle. Based on this, the interest rate on the marginal lending facility could reach a whooping 5%…
Most economists are not buying it. Four-fifths of the 37 economists polled by the FT in December forecast the ECB would stop raising rates in the first six months of 2023 and two-thirds predicted it would start cutting them in 2024 in response to weaker growth.
The ECB expects to begin reducing its balance sheet in 2023
The ECB was hawkish on rates but also set forth its plan on normalizing its balance sheet.
The ECB intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP until the end of February 2023. After February, the APP portfolio will decline “at a measured and predictable pace” as not all principal payments from maturing securities will be reinvested. The ECB stated that the decline will amount to EUR 15 billion per month on average until the end of the of the second quarter of 2023. From March 2023 to June 2023, that would amount to EUR 60 billion of maturing securities that are not reinvested. The situation is to be reevaluated for the period after June 2023.
As for the PEPP, the ECB does not intend to change anything until at least the end of 2024. Principal payments from maturing securities purchased under the PEPP are to be reinvested. The ECB left itself some wiggle room by stating the following:
In any case, the future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance.
If you have any idea what this means, please let me know…
As you know the APP is not one program. I know, it’s confusing because people and institutions, including the ECB in its December 15, 2022 press release, tend to say “the Asset Purchase Program”. The APP is actually the combination of the four asset purchase programs, which are:
- Corporate sector purchase programme (CSPP)
- Public sector purchase programme (PSPP)
- Asset-backed securities purchase programme (ABSPP)
- Third-covered bond purchase programme (CBPP3)
The details surrounding each purchase program are beyond the scope of this post. However, you can find further information on the ECB’s website, here.
All you need to know at this stage is that the CSPP and the PSPP are the two big ones within the APP. The ECB did not say whether the EUR 15 billion of maturing securities that are not reinvested are to be split proportionally across the four programs. If the weightings are different, this could have a significant impact on European corporate bonds.
With such a press release and Lagarde’s hawkish press conference, no wonder why Italian Prime Minister Giorgia Meloni is fretting about the ECB’s monetary policy. Rome’s borrowing costs have risen sharply since the ECB started to hike rates last summer. The 10-year bond yield climbed above 4.6% last week, four times the level twelve months ago and 2.1% above the equivalent German bond yield. Meloni said:
It would be useful if the ECB handled its communication well… otherwise it risks generating not panic but fluctuations on the market that nullify the efforts that governments are making.”
Source: Reuters
Italian public debt remains one of the highest in Europe at just over 145% of GDP…
Do not underestimate inflation
Like the Fed, the ECB raised its inflation forecasts for the euro zone and stated that price growth would remain above its 2% target throughout the projection horizon, which now extends to 2025.
Bear in mind that the ECB has persistently underestimated inflation over the past two years (like the Fed and other central banks to be fair). The ECB’s main worry is that food and services costs are now becoming increasing apparent, making price growth relatively broad.
However, there are signs that inflation is beginning to subside. Spain’s 12-month inflation slowed down again in December to 5.8%. This was the slowest annual pace for the year, due to lower electricity prices compared to a year ago.
Germany will released its inflation figures today. I expect a slowdown too.
Markets might be tempted to price a dovish pivot from the ECB. I would urge caution. Even if inflation is slowing, a rate of 5.8% remains completely unacceptable and is almost three times the ECB’s 2% medium-term target. It’s far from over…
Happy new year 2023! Without you readers, there would be no blog and I wish you the best. If there are any specific topics you are interested in, please let me know and leave a comment!
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