By Konstantin Veit, Portfolio Manager at PIMCO
- After having hiked interest rates back to 0% at its July monetary policy meeting, we believe the ECB will hike policy rates another 50 basis points at its September meeting and communicate that further increases in interest rates will be appropriate.
- We believe the Governing Council (GC) will aim to bring its policy rates into neutral territory reasonably quickly, and expect additional 50 basis point policy rate hikes in October and December as a result.
- 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 seems determined to put the fight against inflation ahead of growth concerns, the macroeconomic configuration remains complex and political risks elevated.
Interest rates: More relevant than the precise journey of rate hikes will be the destination. The market is pricing around 175 basis point of rate hikes by the end of this year, and another 50 basis points over H1 next year. There remains considerable uncertainty where a neutral policy rate for the Euro area might be, but around 1.5% in nominal terms seems reasonable also in comparison to other developed market jurisdictions, such as the UK or US. Current market pricing hence suggests somewhat restrictive territory for the ECB, with a peak policy rate of 2.25% around the middle of next year.
While the larger than previously indicated 50 basis point hike in July has been characterized as frontloading without changing the assessment of the terminal rate in the hiking cycle, and while we do not believe the ECB will provide a lot of guidance regarding the potential destination of interest rates at this stage, 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.
Along those lines, ECB Chief Economist Philip Lane recently reiterated that cyclical factors may require policy rates to move above or below neutral in order for inflation to stabilise at target. The ECB will also release new quarterly staff macroeconomic projections, where we expect another round of substantial downward revisions to growth and upward revisions to inflation. The GC’s lower confidence in its macroeconomic projections has been an increasing pattern in recent months, which suggests that policy decisions may be somewhat less sensitive to staff projections compared to history, and instead more influenced by spot inflation as well as the more direct drivers of medium-term inflation, such as wage developments and various measures of inflation expectations. GC members have argued for more persistence in the inflation process than embedded in models where parameters were maintained at values that had been estimated in a low-inflation environment, even though such values were likely to be changing as inflation moved higher. Hence we believe the ECB will be reluctant to slow the pace of rate hikes until the peak in inflation is judged behind, and, having started hikes with a 50 basis point pace, there appears little reason to change that pace while the monetary policy stance remains accommodative. Lane made the case for a steady pace, that is neither too slow nor too fast, in closing the gap to the terminal rate. We believe the ECB will likely transition towards moving in 25 basis point increments next year, as the hiking cycle pivots from policy normalisation to policy tightening.
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. We believe a discussion around APP reinvestments will start reasonably soon, also in light of advanced Fed and Bank of England (BoE) balance sheet reduction strategies.
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. APP redemptions of public sector holdings are estimated to average around €22bln per month from August 2022 until July 2023, while they have been averaging around €16.5bln per month between August 2021 and July 2022.
Executive Board member Schnabel recently mentioned that she cannot rule out “someone bringing that up” at the September meeting, and while we do not believe the ECB will aggressively sell down government bond holdings anytime soon, we expect some communication regarding the size of the ECB balance sheet at one of the next policy meetings, as the ECB moves policy rates towards the lower end of neutral range estimates. 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“. Details were not provided, but we expect a decision on the remuneration of reserves to be taken as early as at the September meeting. 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. In our baseline we believe the ECB will not change the TLTRO terms and expect most bank reserves to get remunerated at the deposit facility rate, except part of reserves related to TLTRO borrowings. This should 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.
Normalizing policy rates in a context of €4.5trn excess liquidity and collateral scarcity risks impairing the monetary policy transmission, hence we expect the ECB to explore options to better control money market rates, potentially along the lines of the Fed’s reverse repo facility. 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 very 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 program.