FRANKFURT — The European Central Bank is set to end a year-long sequence of interest rates hikes this Thursday and usher in a policy pause that is expected to stretch well into next year.
The base case for all 85 economists in a recent Reuters survey is that the pause will ultimately come to represent the start of a plateau for interest rates, as a weakening economy removes the need for further hikes. The bank raised its key deposit rate to a record 4 percent in September with a 10th straight hike — by far the most aggressive tightening of monetary policy in its 25-year existence.
With the Eurozone economy now expected to stagnate or even contract in the second half of this year, the majority of economists expect the ECB’s next move to be a cut — albeit not until the third quarter of next year.
Against that backdrop, President Christine Lagarde is expected to play for time at her regular press conference after the meeting. That’s partly because uncertainty over the outlook is still so high, and the inflation monster is still not slain.
“While inflation continues to decline, the attacks on Israel — and the potential knock-on effects on the oil market — pose a new upside risk,” said Natixis economist Dirk Schumacher. “Downside risks to growth, at the same time, have also increased, complicating the picture further for the ECB.”
The future path of interest rates, always the core point of interest, is unlikely to become clear until the spring, policymakers have said in recent weeks. Chief Economist Philip Lane said he will not feel comfortable to sound the all clear on inflation before having seen the outcome of wage negotiations across the bloc in the first quarter. Two fellow policymakers, granted anonymity to speak freely, told POLITICO that the outcome of wage rounds will determine whether they push for further rate hikes.
PEPP talk but no action
The Governing Council thus has some breathing space to discuss other policy issues, with a discussion about an early reduction to its pandemic-era bond portfolio at the top of the agenda.
Several Governing Council members have said the ECB should stop reinvesting proceeds from maturing bonds bought under the so-called PEPP program earlier than the currently scheduled date at the end of 2024. This would bring balance sheet policy closer into line with what the ECB is trying to do with higher interest rates.
In an interview with POLITICO earlier this month, Luxembourg’s central bank Governor Gaston Reinesch suggested the decision for an early reduction should be taken in December. Giving markets sufficient lead-time, that would imply a gradual runoff of the PEPP portfolio as early as the second quarter. BNP Paribas’ Paul Hollingsworth thinks Reinesch and fellow hawks on the Council will prevail and bets on this scenario.
However, Natixis’ Schumacher and others think that the bond market volatility since the September meeting will put the debate on hold. A widening in yield spreads — Italy’s 10-year benchmark bond now pays over 2 percent more than Germany’s — has raised fears that markets may slip into a self-reinforcing spiral driving up the borrowing costs of individual member states. The PEPP is the ECB’s first line of defense against such risks: as bonds from around the bloc mature, it can reinvest more, proportionally, in the bonds of pressured countries, thus keeping a lid on their yields.
‘Divisions running deep’
Another possible move Governing Council members have discussed actively in public is whether to raise so-called minimum reserve requirements, that is the amount of cash it requires banks to park at the ECB overnight at zero interest.
Any increase in reserve requirements would reduce the overall quantity of funds available for banks to lend to the economy. In addition, it would cost eurozone banks billions of euros in interest that the ECB currently pays on their excess liquidity. That could squeeze their profitability and further restrict their willingness to lend, or lead them to claw back part of that lost revenue by raising the cost of the loans they give.
The discussion was kicked off earlier this year by a letter from Bundesbank President Joachim Nagel and has since culminated in Austrian central bank chief Robert Holzmann calling for an increase from 1 percent to 10 percent of deposits – a move described by the chief financial officer of Germany’s Commerzbank as “crazy”.
Some policymakers have signaled support for a more moderate adjustment of 2-4 percent, but as Barclays economist Mariano Cena points out, this is “a controversial issue, with divisions among Governing Council members running deep.”
Given the complexities involved, Governing Council members Pierre Wunsch and Reinesch told POLITICO that the decision should be revisited as part of the overall review of the ECB’s operational framework, when the ECB decides how to conduct monetary policy in future. This will include a decision on the future size of the ECB’s balance sheet and, by extension, how aggressively it will need to be reduced or managed.
The ECB had hoped to conclude this review by year-end, but the ongoing focus on near-term interest rate policy had derailed such plans. The new target is to conclude the review by the end of the first quarter. That may give policymakers time to bridge their differences.
This week’s meeting is the Governing Council’s annual ‘external’ meeting, taking place in Greece for the first time since that country’s epic struggle with default a decade ago. As such, Lagarde is likely to devote a large part of her regular press conference talking up the progress of her host country.
Last week, Greece’s sovereign investment grade credit rating was restored by Standard & Poor’s for the first time since it brought the eurozone to the brink of disaster with its profligacy in 2011, and its economy this year has been one of the eurozone’s few bright spots, helped by a post-pandemic boom in tourism and a steady reduction in political risk, reinforced by the reelection of Kyriakos Mitsotakis’ center-right government in the spring.
