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ECB Preview: Towards Restrictive

By Konstantin Veit, Portfolio Manager at PIMCO

Summary:

  • Inflationary pressures remain elevated and we believe the European Central Bank (ECB) will hike policy rates 50 basis points at its December meeting, and indicate that it expects to raise interest rates further.
  • We expect the Governing Council (GC) to 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.
  • On Thursday, the ECB will also release key balance sheet reduction principles, with the most likely implication being a passive reduction of its standard asset purchase program (APP) holdings, starting around Q2 next year.
  • We expect the ECB’s projections for the 2024 core and headline inflation numbers to have changed minimally compared to September and therefore remain somewhat above target, while the inaugural 2025 inflation projections will likely be very close to the ECB’s 2% price stability objective.

 

Additional thoughts:

  • Interest rates
    • 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 suggests a somewhat restrictive destination for the ECB, with a peak policy rate of 2.9% 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.
    • 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 or early next year, and decline fairly consistently throughout the course of next year.
  • Balance sheet
    • At the upcoming meeting, we expect the ECB will lay out the key principles for reducing the bond holdings in its APP portfolio. This broad roadmap will subsequently convert into a more precise plan delivered at its February or March meeting, that will allow for the APP portfolio to decline at a certain pace.
    • We believe the ECB will communicate that, while the GC continues to view the set of policy rates as the primary monetary policy instrument, it is appropriate that the balance sheet is normalised in a measured and predictable way over time.
    • For pandemic emergency purchase programme (PEPP), the GC currently intends to reinvest principal payments from maturing securities until at least the end of 2024. We expect the ECB to clarify that the tools for safeguarding the orderly transmission of monetary policy, notably flexible reinvestments under the PEPP and the new transmission protection instrument (TPI), will remain in place and PEPP reinvestments will remain as the first line of defense in the ECB’s anti-fragmentation toolkit.
    • In our baseline, we expect some form of passive APP run-off starting next year, implying an annual unwind of up to €264bln of public sector securities in the case of a hard stop to APP reinvestments. A more likely scenario entails a gradual reduction of reinvestments over time.
    • Regarding the targeted longer-term refinancing operations (TLTRO), a run-off of the €1.82trn TLTRO would see the ECB balance sheet shrink by around 21% until the end of 2024. As such, regular TLTRO maturities and early repayments will constitute the lion’s share of the ECB’s balance sheet reduction over the next two years. Nevertheless, excess liquidity will likely remain elevated over the medium term, hence we believe the deposit facility rate will continue to serve as the main policy rate for the foreseeable future.
  • Economic projections
    • In the ECB economic projections, their near term growth path will now potentially foresee a mild and short recession starting in Q4 of this year, with two consecutive quarters of negative growth in Q4 22 and Q1 23, followed by a recovery that gains steam during the summer and into end-2023.

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