The European Central Bank (ECB) raised its deposit facility rate by another 50 basis points (BP) to 2% at the December meeting, bringing its policy rate to the upper end of most estimates for a neutral configuration for the Euro area, namely 1.25% to 2%.
The ECB made clear it expects to raise interest rates significantly into restrictive territory, aiming to ensure the timely return of inflation to its medium-term target of 2% – Euro area inflation has been running at about 10%. Indeed, the new Eurosystem staff macroeconomic projections foresee inflation above the ECB’s definition of price stability for the entire three-year projection horizon. A peak policy rate of around 3.25% priced in by the market doesn’t look unreasonable given the still large uncertainty over inflation dynamics, and relative to other major developed market jurisdictions such as the U.K. or U.S.
The balance sheet reduction principles implicitly acknowledge the institutional Euro area setup, suggesting limited scope for the ECB to entertain trade-offs between quantitative tightening and policy rates. Any bond-holding reduction exercise will essentially take the shape of a background programme. The ECB is keen to avoid a situation such as when the Bank of England intended to reduce bond holdings for monetary policy purposes but acquired bonds on financial stability grounds instead.
The main implication of ECB balance sheet normalization will be considerably higher bond issuance to the market, and we expect net European government bond supply to more than double next year. Together with measures taken to better control money market rates and preserve the monetary policy transmission mechanism, this should continue to result in an easing of collateral scarcity, and help restore a more balanced relationship between European interest rate swaps and core government bond market pricing.
When will the ECB stop raising rates?
ECB President Christine Lagarde during the press conference emphasized that there is no forward guidance on interest rates, and the ECB remains firmly in meeting-by-meeting mode with inflation dynamics driving the future policy rate path. However, she also made clear that the pre-meeting market pricing of a 3% terminal rate is not judged sufficiently restrictive – and opened the door for additional 50-bp rate hikes at upcoming monetary policy meetings.
Our conviction remains low on the pace and scope of ECB rate hikes, given the unknowns around the evolution of inflation. As such, we don’t disagree with the terminal rate currently priced in by the market, particularly after the somewhat hawkish posture adopted at the December meeting. Another 50-bp rate hike at the next meeting in February seems like a done deal, while visibility beyond the very near term remains low.
What about the balance sheet?
The ECB communicated that, while its governing council continues to view 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. The central bank also clarified that the tools for safeguarding the orderly transmission of monetary policy – notably flexible reinvestments under the pandemic emergency purchase programme and the new transmission-protection instrument – will remain in place.
While the ECB did not rule out selling bond holdings, the principles focus on a gradual, orderly, and passive reduction of its regular asset purchase programme (APP) reinvestments, a strategy supported by the relatively favourable maturity structure of its bond portfolio.
From March 2023 onwards, APP reinvestments will decline by around €15 billion per month on average until the end of the second quarter, and its subsequent pace will be determined over time. In our baseline forecast, we expect this passive APP run-off to continue at a 50% reinvestment schedule beyond Q2 next year. For reference, the ECB balance sheet currently stands at around €8.5 trillion.
What about the staff forecasts?
The ECB also released the new Eurosystem (which comprises the ECB and the national central banks of EU member states whose currency is the euro) quarterly staff macroeconomic projections, including its inaugural 2025 estimates. For 2023, the December projections unsurprisingly featured solidly higher inflation and lower growth compared to the September exercise.
For 2024 and 2025, the projections had to balance the knock-on effects of inflation (for example, on the wage mechanism) with now considerably tighter financial conditions as a result of monetary policy reducing support for demand and guarding against unwarranted second-round effects.
The ECB acknowledged that the Euro area economy may contract in the current and next quarter, but believes any recession would be relatively shallow and short-lived. The 2024 and 2025 growth numbers essentially project growth close to the Euro area trend.
The 2024 core and headline inflation numbers were revised upward compared to September and therefore are solidly above target, while the inaugural 2025 inflation projections are closer to the ECB’s 2% price stability objective. Nevertheless, at 2.3% headline and 2.4% core inflation, these projections suggest there is yet more ground for the ECB to cover in its current policy tightening cycle.
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