ECB Sketches Out Policy Shift That Isn’t Quite Tightening

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European Central Bank officials grappling with the question of how to wean the euro area off ultra-loose stimulus are starting to sketch out a monetary policy path that remains far less aggressive than global peers. 

In contrast to tightening efforts by the U.S. Federal Reserve and Bank of England that have prompted investors to bet on such moves in the euro zone, Governing Council members are focusing on potential “normalizing” as they ponder an inflation outlook close to their 2% goal. 

Such rhetoric, emphasizing the need for economic support amid insufficient confidence that consumer-price gains will become self-sustaining, was recently hinted at by Chief Economist Philip Lane. It suggests that the search is on for a sweet spot where euro-zone monetary policy is neither accommodative nor restrictive.  

That's a backdrop to the Governing Council's meeting on Thursday, the first since its decision to halt emergency purchases in March and slow overall bond-buying this year. Any debate on future stimulus withdrawal is likely to weigh interest-rate increases along with shrinking the ECB's 8.6 trillion-euro ($9.7 trillion) balance sheet. 

“They'll need to be patient and flexible and gradual to keep the recovery going,” said Agnes Belaisch, chief European strategist at Baring Investment Services Limited. “They'll be able to do that as long as their guidance is clear.”

That isn't easy. With tightening under way globally, investors are pricing in a quarter-point ECB rate increase before the end of this year. Such bets have been bolstered by faster-than-anticipated consumer-price increases. On Wednesday, euro-zone inflation unexpectedly accelerated to 5.1%, the highest since the single currency's creation.

Officials protest that such a move isn't justified by current guidance, a view accepted by economists surveyed by Bloomberg who predict quantitative easing will end in March 2023, followed by a rate increase six months later. 

“They've painted themselves into a bit of a corner by insisting on no rate hikes this year,” said Anatoli Annenkov, senior economist at Societe Generale SA. “It's hard to turn around this supertanker.”

What Bloomberg Economics Says...

“The potential for a hawkish pivot has been on the Bloomberg Economics radar for a while and we see three plausible routes to a rate hike this year. Reflecting on the risks, we still don't see a 2022 base case, but we've brought forward our forecast for a hike by six months to June 2023.”

--Jamie Rush. For the full report, click here 

The ECB's benign outlook stands in stark relief to counterparts such as the Fed, which is preparing to raise rates in March and might also start considering a significant reduction in its balance sheet later in the year. The BOE meanwhile could deliver a second hike as soon as this week in what would be its first back-to-back move since 2004. 

While headline inflation is surging throughout the advanced world, the ECB's less aggressive outlook reflects its view that price pressures aren't becoming entrenched. Wage increases remain largely muted, while powerful downward forces such as aging demographics and weak productivity growth haven't dissipated.

Its latest projections show inflation at 1.8% in 2023 and 2024. Lane said last week that a scenario persistently above 2% would require “serious tightening” but is less likely. However inflation could stabilize at the goal, an outcome where “clearly over time we would normalize monetary policy,” he said.

What exactly that means isn't immediately clear. For Dario Perkins, chief European economist at TS Lombard in London, it might entail the sort of monetary policy that the ECB was pursuing before the pandemic. 

“Normalizing for the ECB will be getting out of quantitative easing,” he said.

Bank of France Governor Francois Villeroy de Galhau's own detailed suggestion includes a “gradual and sequential approach” of tapering, a liftoff in rates, and then downsizing the balance sheet. 

Those Jan. 19 comments by the Frenchman avoided any mention of the word “tightening,” an omission that isn't surprising given the difficulty in determining what so-called neutral policy settings in the euro zone would be. 

The region's equilibrium rate -- the level that neither stimulates nor constricts activity, often referred to as R* -- was around 0.5% at the end of 2019, according to a model developed by Fed officials. 

But it's hard to judge how the pandemic has shifted that, and some economists caution that the economic costs of overestimating the level may be greater than judging it too low.

Belaisch at Barings says whatever the ECB does will entail a slow approach. While she reckons the deposit rate, currently at -0.5%, will ultimately settle between 1.5% and 2%, it will take time to get there. 

What will be easier will be shrinking the ECB's balance sheet. That's because, aside from 4.8 trillion euros of assets accumulated under purchase programs which will mostly be reinvested, it has also handed banks more than 2.2 trillion euros in long-term loans. 

While the last of the so-called TLTROs expires in March 2024, about half may be repaid later this year, according to Giuseppe Maraffino, a rates strategist at Barclays Bank Plc. That would take the balance sheet to levels last recorded in June last year. 

But for Perkins at TS Lombard, the ECB can't really embrace genuine policy tightening until Europe's economy starts to show a transformational revival, requiring determined fiscal spending to raise its growth potential. 

“That's our best chance to come back to a world where the ECB can really normalize policy,” he said.

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