European central bank policy makers will meet in Amsterdam on Thursday for their annual out-of-Frankfurt meeting at the invitation of Klaas Knot, the Dutch central bank governor who is known for his hawkish approach to interest rates and his support of a 50 basis point rate hike in July.
Knot has repeatedly called for hefty hike in the ECB’s Eurozone benchmark interest rates, a position that puts him at odds with dovish members of the ECB’s governing council who are keen to protect the vulnerable economies in the eurozone such as Italy and Greece.
It has taken ECB President Christine Lagarde some time to throw her weight behind a eurozone rate hike that would seek to quell rising inflation rates in Europe. But Lagarde, in her 23 May ECB blog post, made clear that she now expects the bank will raise Eurozone rates at its July policy meeting in Frankfurt.
Vulnerable eurozone countries
Thursday’s meeting in Amsterdam is expected to shed further light on the ECB’s next step: halting its asset purchasing programme that has supported Europe’s businesses and households for the last seven years. This step may be particularly difficult to digest for some of the weaker eurozone countries whose debts will be challenged by rising interest rates.
The ECB is said to prepare a special contingency programme that could be activated in the event that market sell-off hits the debt markets of weaker eurozone countries. Citing people familiar with the discussions, the Financial Times on Tuesday reported that a majority of the 25-member ECB policy council is in favour of such a special bond-buying programme.
"This approach enhances the window for the ECB to simultaneously tighten monetary policy in the face of high inflation and counter widening pressure on the risk spreads of the weaker members of the Eurozone," said economist and central bank watcher Mohamed El-Erian in a LinkedIn post.
Ending the Asset Purchasing Programme, or APP, the ECB has said, is a precondition for raising eurozone rates.
Clear path out of negative rates
“The ECB are expected to end net asset purchases at their next meeting, and signal a clear path out of negative rates territory over the coming months,” said Katharine Neiss, Chief European Economist at PGIM Fixed Income.
“The open question is: where do the ECB go from there? The Russia-Ukraine conflict and associated energy shock have yet to feed through to the euro area real economy. Given the scale of the shock and the potential that further downside risks crystalise, the ECB would do well to tread carefully in raising rates well above zero for the first time in nearly a decade.”
At Pictet Wealth Management, Frederik Ducrozet, Head of Macroeconomic Research, en Nadia Gharbi, Senior Economist, said they anticipate 25 basis point hikes by the ECB in July, September and December, to bring the deposit rate to +0.25 percent by the end of the year.
The option of a more hawkish 50 basis point hike remains on the table. “While we expect the ECB to go with the safer option of a 25bp hike in July, recent inflation data have increased the probability of a 50bp move,” said Pictet. “Lagarde did not explicitly ruled out the option, neither did Philip Lane although the Chief economist backed a ‘gradual’ normalisation process in the form of a “benchmark pace” of quarterly 25bp hikes.”
Inflation indicators will shape size of rate hike
Pictet sees a number of wild cards that could tip the balance ahead of the July ECB meeting. This includes eurozone inflation data to be released on 1 July and the Survey of Professional Forecasters, which will be available to the ECB council ahead of its public release a day after its July meeting.
“Isabel Schnabel and several GC members have expressed their concerns over a potential de-anchoring of inflation expectations, which may require a stronger policy signal at the early stage of the normalisation process,” Pictet said. “The market is pricing around 15bp of premium on top of two 25bp rate hikes in July and September, so the hawks could argue that the surprise would be limited. We believe that the likelihood of a 50bp hike in September has increased substantially.”
ECB to prepare for QT?
Europe so far has seen little discussion about what is further down the line in terms of monetary policy. The Federal Reserve, when hiking its rates on 5 May, immediately switched from quantitative easing to tightening, selling Treasuries and mortgage-backed securities at a rate of 47.5 billion dollars per month. This tightening will increase of 95 billion dollars per month from September.
“The discussion around Quantitative Tightening has not yet started in the euro area, based on the ECB’s stronger guidance on reinvestments,” said Pictet. “Looking ahead, the risk is that APP (Asset Purchasing Programme, ed.) reinvestments become increasingly difficult to justify. Under the current guidance, APP reinvestments are expected to continue ‘for an extended period of time’ past the date of lift-off, but they were also designed to last “for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation”. The latter can hardly be justified any more, and markets may start pondering the risk of QT down the road.”
