Zero Is a Good Destination for ECB Interest Rates

(Bloomberg Opinion) -- Who would be a central banker in these febrile times, trying to navigate a path between soaring prices and a gloomy growth outlook? While policy makers everywhere face similar challenges, the European Central Bank's task is particularly tricky given its deeply negative interest rates. With the money market pricing in a rapid climb in borrowing costs that would threaten to tip the bloc into recession, a monetary compromise is needed.

Europe is far more exposed to the energy risks stemming from Russia's invasion of Ukraine. Moreover, the geographical proximity of the war is causing a humanitarian crisis and raises the prospect of real economic hardship in the region.

Germany's annual inflation rate soared to 7.6% in March, with Wednesday's figures outstripping economists' forecasts for a rise to 6.8%. Spanish consumer prices were also a shocker, climbing by 9.8% versus the 8% consensus estimate. Friday's euro-zone number looks set to surpass the 6.7% rate anticipated by economists. And the ECB's forecast for inflation to average 5.1% this year, made just a few weeks ago, already looks hopelessly optimistic, with economists at UniCredit SpA predicting 6.45% and Danske Bank A/S seeing 7%.

Meantime, the growth outlook is deteriorating rapidly. This week, Germany's Council of Economic Experts slashed its 2022 forecast for expansion in Europe's biggest economy to 1.8% from 4.6% previously. Economists were already predicting a slower expansion for the euro region than the ECB's latest projection.

Moreover, the German government advisers warned of a “considerable risk” of growth slowing enough to make a recession possible because of the country's dependence on Russian oil. Earlier this month, economists surveyed by Bloomberg put the likelihood of two consecutive quarters of output contracting in the euro zone at 30%, the highest since Covid lockdowns prompted similar concerns a year ago.

But with the Federal Reserve and the Bank of England both raising interest rates, the ECB is in danger of looking out of step if it doesn't do something to show it's paying attention to its price stability mandate. Its deposit rate is currently -0.5%; the swaps market is pricing in more than half a point of increases by the end of the year. A "significant minority" of the Governing Council is clearly agitating for an end to quantitative easing this summer, paving the way for borrowing costs to move higher.

ECB Chief Economist Philip Lane laid out the daunting task ahead in an interview with Politico published this week. He cited a drop in economic sentiment as a "major concern" for policy makers, stressing that inflation is expected to ease back below target next year and highlighting that the central bank is seeking “flexibility and optionality” in its monetary framework.

Nonetheless, unless the outlook set out in its quarterly review on March 10 alters dramatically, the ECB's 3.2 trillion-euro ($3.5 trillion) asset-purchase program will finally stop growing sometime in the third quarter. Lane stipulated that it would require "a significant decline in the medium-term inflation outlook" at its next economic review on June 9 for QE purchases to continue.

Freezing the ECB's asset-purchase programs will be a seminal moment. It will immediately raise the issue of how soon will interest rates rise, and Lane was suitably equivocal. The ECB carefully moved to give itself more wiggle room at its last meeting, so a rate hike will no longer necessarily happen "soon after" but "sometime after" QE ends.

Ending the year with the official rate at zero would be a balanced approach, neither stimulative in the face of faster inflation nor restrictive given the outlook for weaker growth. It would echo the kinds of compromise the euro project was built on, delivering less tightening than the market is expecting and giving elbow room to react to whatever challenges the economy poses in future. “An increase in the deposit rate to 0% by the end of the year would be important for monetary policy because that increases our optionality,” ECB Governing Council member Robert Holzmann told Boersen-Zeitung in an interview published this week.

President Christine Lagarde will be asked repeatedly at next month's post-meeting press conference whether the market is correctly betting on higher rates this year. Giving clear forward guidance by signaling that the deposit rate is likely to move toward zero but isn't headed much higher than that would help prevent financial conditions from getting too restrictive. Moving away from negative rates would be a significant step in normalizing monetary conditions in the euro area. Other central banks have stolen a march — time for the ECB to lace up its boots, but not too tightly.

More From Bloomberg Opinion:

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.