Frederik Ducrozet, Head of Macroeconomic Research, en Nadia Gharbi, Senior Economist Pictet Wealth Management.
Rushing for the NIRP exit. Our baseline scenario is for the ECB to hike by 25bp in July, September, and December, bringing the deposit rate to +0.25% by year-end. Next week, the GC will almost certainly announce the end of net asset purchases under the APP in early July, while effectively committing to hiking rates at the 21 July meeting, in line with the ‘clarification’ provided by President Christine Lagarde in her blog. The statement should be adjusted accordingly, noting that it has become appropriate to start removing policy accommodation.
The 50bp option will remain on the table. While we expect the ECB to go with the safer option of a 25bp hike in July, recent inflation data (see our previous email here) have increased the probability of a 50bp move. Lagarde did not explicitly ruled out the option, neither did Philip Lane although the Chief economist backed a “gradual” normalisation process in the form of a “benchmark pace” of quarterly 25bp hikes.
There are a couple of wildcards that could tip the balance ahead of the July meeting, including the June HICP print (released 1 July), and the Survey of Professional Forecasters (released 22 July, but available to the GC ahead of the 21 July meeting).
We forecast euro area core HICP inflation to hover around 4% until the end of the year, before easing only slowly into 2023. In this context, Isabel Schnabel and several GC members have expressed their concerns over a potential de-anchoring of inflation expectations, which may require a stronger policy signal at the early stage of the normalisation process. The market is pricing around 15bp of premium on top of two 25bp rate hikes in July and September, so the hawks could argue that the surprise would be limited. We will be watching the ECB’s statement and the Q&A session closely for any hint at the possibility of larger rate hikes.
Meanwhile risks to activity remain tilted to the downside, but leading indicators have not weakened enough to challenge the ECB’s plans. Staff projections will be revised lower for GDP growth, but inflation will still be revised higher through 2023. A key focus will be on the 2024 projections (both headline and core inflation currently stand at 1.9%), as a wider output gap would be consistent with lower core inflation but higher inflation persistence and wage growth may well push the medium-term projection above 2%. That would be first time since the ECB started publishing quarterly projections. If inflation needs to be revised even higher in September and/or wage negotiations are pointing to higher risks of a wage-price spiral, the hawks will be in a stronger position to push for faster policy normalisation. For all these reasons, we believe that the likelihood of a 50bp hike in September has increased substantially.
Normalisation, not tightening, until something breaks. The more important question, in our view, is whether the ECB will be in a position to hike rates further above zero, towards levels close to ‘neutral’, or even higher. This will depend on several factors, including the war in Ukraine, the volatility in the peripheral bond market, but also changes in the fiscal impulse, and the pace of Fed tightening.
Some GC members have expressed their views on the neutral rate, with estimates ranging between 1% and 2% in nominal terms. Our pragmatic view is that the neutral rate can hardly be estimated in real time. We expect the ECB to hike rates by 25bp each quarter until ‘something breaks’, either in the real economy or in the peripheral bond market. We suspect that reaching neutral or even slightly restrictive policy rates will take longer than market are anticipating at the moment.
QE backstop. We do not expect the ECB to provide much clarity about a new backstop for peripheral spreads next week. Crucially, the re-pricing in rates markets has been fairly broad-based and orderly so far, with Italian BTP spreads tracking euro IG credit spreads closely since the pandemic (see chart below). We reiterate our view that the hawks should be the ones pushing for a credible backstop for bond spreads as a necessary condition for the ECB to keep hiking rates beyond September. However, the bar for ECB intervention is higher today than it was in the past, and constructive ambiguity will likely prevail for now. A spread control tool could be implemented if Italian bond spreads started to widen in a more idiosyncratic way, for instance ahead of new elections in 2023.
PEPP reinvestment. Instead, the first line of defense should come with more flexible PEPP reinvestments which we estimate at around €200bn per year, with another €225bn in PSPP redemptions over the next twelve months. The GC could state more explicitly how it intends to adjust PEPP reinvestments “flexibly across time, asset classes and jurisdictions” in the event of an unwarranted fragmentation of financial conditions.
(Green) TLTROs. The ECB is expected to confirm the end of the TLTRO 50bp rate discount next week. We don’t expect new liquidity facilities to be implemented until later this year. Specifically, the ECB could consider green lending facilities following Lagarde’s commentsyesterday.
QT next? The discussion around Quantitative Tightening (QT) has not yet started in the euro area, based on the ECB’s stronger guidance on reinvestments. Looking ahead, the risk is that APP reinvestments become increasingly difficult to justify. Under the current guidance, APP reinvestments are expected to continue “for an extended period of time” past the date of lift-off, but they were also designed to last “for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation”. The latter can hardly be justified any more, and markets may start pondering the risk of QT down the road.
