The ECB is preparing the ground for rate hikes once the stimulus program is completed

The ECB is preparing the ground for rate hikes once the stimulus program is completed

On Thursday, the European Central Bank will end years of stimulus and announce a series of rate hikes to combat rising inflation, leaving markets to guesstimate the magnitude and speed of policy tightening. With inflation reaching an all-time high of 8.1 percent and widening rapidly, the ECB has already signalled a number of actions in an attempt to prevent rapid price growth from devolving into a difficult-to-break wage-price spiral.

Everything else, including the size of the initial rate increase from minus 0.5%, is likely to be left open, with ECB chief Christine Lagarde emphasizing flexibility and optionality. While the ECB’s own chief economist has signaled a preference for 25-basis-point hikes, inflation is rising so quickly that sentiment could easily change over the next six weeks.

Details remain difficult, however, because forecasting inflation has proven impossible, implying that the ECB will only announce its early moves on Thursday and maintain a high level of discretion thereafter. What appears certain is that the ECB will end its long-running Asset Purchase Programme at the end of this month, promise a rate hike on July 21 and signal that the deposit rate will be out of negative territory sometime in the third quarter.

Already, several policymakers have said that a bigger increase needs to remain in play as inflation expectations were at risk of “de-anchoring”, central banks speak for when businesses and households lose trust in the bank’s willingness to rein in prices. Supporting their case, new economic projections from the ECB could indicate that inflation across the 19 countries that use the euro holds above the 2% target through 2024, pointing to four straight years of overshooting.

Markets are pricing in 139 basis points of rate hikes by the end of this year, or an increase at every meeting from July, with some of the moves in excess of 25 basis points. They are also anticipating a combined 230 basis point of moves by the end of 2023. That leaves the ECB in a tricky position, just months after Lagarde said that a rate hike this year was highly unlikely.

“The likelihood of a 50-basis-point hike is rising by the day,” Moody’s Analytics senior economist Kamil Kovar said. “We currently view a 50-basis-point hike in July as possible but unlikely. In contrast, a 50-basis-point hike in September is as likely as it is unlikely at this point.” “It is even possible that the bank will resort to multiple 50-basis-point hikes,” he said.

If she ignores markets, even more, aggressive tightening might be priced in, unnecessarily pushing up borrowing costs. But if she pushes back strongly, the ECB president might signal a commitment that could become obsolete within weeks, much like the no rate increase pledge.

The ECB’s first rate hike in over a decade would still leave it trailing most of its global peers, including the U.S. Federal Reserve and the Bank of England, which have been rising aggressively and promising even more action. “The only discussion seems to be on whether the ECB should start with a 25 basis point rate hike in July or already a 50 basis point hike,” ING economist Carsten Brzeski said.

While the start of policy tightening is now set, the endpoint remains uncertain. Lagarde has said that rates should move towards the neutral point at which the ECB is neither simulating nor holding back growth. But this level is undefined and unobservable, leaving investors guessing just how far the ECB wants to go. “In our view, the ‘neutral’ rate … is around 2%,” Berenberg economist Holger Schmieding said. “We expect the ECB’s main refinancing rate – currently 0.0% – to reach this level in mid-2024 after three rate hikes of 25 basis points in the second half of 2022, three such moves in 2023, and two further increases in the first half of 2024”.

The main refinancing rate is formally the ECB’s benchmark but it has used the rate on its overnight deposit facilities for banks as its main policy rate for much of the past decade given that banks have piled up hundreds of billions of euros worth of excess liquidity. Another question is how the ECB will handle the divergence in borrowing costs of various member states. Nations with bigger debt piles, such as Italy, Spain, and Greece, have already seen a sharper increase in borrowing costs – a headache for the ECB’s one-size-fits-all monetary policy. While the ECB promised to fight “unwarranted fragmentation” it has yet to define unwarranted and has not said what action it would take to tackle it. Lagarde could clarify these points but she is unlikely to announce a specific tool at Thursday’s meeting in Amsterdam, emphasizing instead the ECB’s flexibility and commitment to act quickly in case of market turmoil.

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