Sent October 24, 2022, 7:00 am
The European Central Bank will kick off a new round of monetary policy meetings on Thursday. It will be followed by the Federal Reserve on November 2nd and the Bank of England the following day. The reaction of the markets to the decisions taken in Frankfurt will be a test case, in a climate of great nervousness, as demonstrated by the recent British debt crisis.
Still record inflation
The euro zone narrowly escaped double-digit inflation. Eurostat revised the size of the September price increase to 9.9%, instead of 10%. However, this is a new record.
The response of the European Central Bank is certainly not in doubt. Markets are unanimously betting on a further hike of 75 basis points. The hard-line “hawks” seem to have won without actually fighting. “Unlike the rush to the July and September meetings, there was no public controversy among the governors about the extent of the rate hike,” said ING economist Carsten Brzeski. The deposit rate would then rise to 1.5%, the highest level since January 2009.
A maximum rate to be defined
Now, for investors, the real question is about the “terminal” or final rate. In other words, to what extent is the ECB ready to raise the cost of borrowing? The only certainty is that the Frankfurt institution should reach the neutral rate (around 2%) by the end of the year. This means that in December it will raise the deposit rate by another 50 basis points to reach that level, where it neither slows down nor accelerates the economy.
To curb inflation, the ECB will have to go further. For ING there will be a further increase of 25 basis points in February, then it will take a break. The markets are more aggressive and see a deposit rate above 3% in the summer. They may need to revise their forecasts to the downside. While fighting inflation remains its priority, the ECB may be reluctant to fuel the surge in government bond yields. And the recession announced in the euro zone next year will make the crackdown more complicated.
A delicate reduction of the budget
The ECB will be eagerly awaited by the reduction of its balance sheet, which has risen to € 9 trillion as a result of its asset purchase programs to support the economy. “The start of a“ quantitative tightening ”would reinforce the effect of the rate hike [dans la lutte contre l’inflation] explains Eric Dor, head of economic studies at IESEG. The ECB would stop reinvesting the amounts resulting from the redemption of portfolio securities which have reached maturity. For its main purchasing program (APP), this would represent a reduction of the order of 250 billion euros per year.
This central bank withdrawal from the bond market is likely to cause renewed strain on government borrowing costs. For now, the interest rate differential between Germany and Italy is around 250 basis points, just below the “pain threshold”. The end of the ECB’s purchases could cause it to jump, which would weaken the euro zone.
Bank liquidity to manage
This is a problem that affects the central bank to the wallet. When rates were still negative, banks paid the central bank to hold their cash. With the increase in the deposit rate, the ECB had to start remunerating the approximately € 4 trillion of excess bank reserves. That is, the amounts above the minimum reserve requirement that they impose on Frankfurt. From now on, pay them 0.75% interest and, a priori, 1.5% from next month.
However, much of these bank deposits come from very advantageous loans offered by the ECB to banks during the crisis. These loans (the TLTROs) are partly at negative rates. As a result, banks that are already earning profits by borrowing from the ECB also earn money through their deposits.
To reduce this unexpected effect, several solutions have been considered. In particular, the ex post increase in the TLTRO rate. But it is rather the hypothesis of a differentiated remuneration of bank reserves that holds the rope. “The banks would then be paid at 0% for an amount corresponding to the TLTROs subscribed and the deposit rate for the balance,” Frederik Ducrozet told Pictet.