ECB Sticks to Gradual Stimulus Exit as Bets on Hikes Build

(Bloomberg) -- The European Central Bank renewed its pledge to withdraw pandemic stimulus only gradually, even after a record inflation reading fed market expectations for a first interest-rate hike in more than a decade this year.

A day after data showed the steepest euro-area price gains on record -- defying predictions for a lessened pace -- the Governing Council on Thursday reiterated that it will slow bond-buying across 2022 and end asset purchases entirely before raising borrowing costs.

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Affirming the plan underscores the widening divergence with the more aggressive monetary-policy tightening under way in the U.S. and the U.K. On Thursday, the Bank of England lifted rates by a quarter point for a second straight meeting, in a close-run decision where four officials had sought an even bigger increase.

The ECB position also signals that policy makers in Frankfurt are sticking to their guns on elevated inflation abating once energy costs and supply-chain snarls ease. Prices jumped 5.1% last month -- more than double the 2% target.

While President Christine Lagarde insists a rate hike is unlikely this year, money markets are increasingly skeptical. They predict a 10 basis-point increase from the ECB by September and on Wednesday briefly brought that forward to July. They now see almost 30 basis points of tightening by year end. The euro declined and German bonds pared losses after the decision.

The focus for investors will be whether Lagarde reveals any signs of hawkishness at her news conference at 2:30 p.m. in Frankfurt.

What Bloomberg Economics Says...
“Market participants are likely to focus in February on the Governing Council's risk assessment, with the language on inflation grabbing the most attention.”
--David Powell, senior euro-area economist. For full React, click here

A key question for the ECB chief is how the institution's latest projections stand up in light of this week's data shock. Just two months ago, officials predicted inflation would return to 1.8% in 2023 and 2024.

Any upward revision could mean the conditions for a rate hike are close to being met and may force policy makers to rethink their plans. New ECB projections are due in March.

Lagarde will need to strike a delicate balance between holding market expectations at bay while refraining from promises that may need to be walked back later. She'll also need to address sources of heightened uncertainty.

Record Covid-19 infections and persistent shortages of manufacturing components continue to provide headwinds, while an escalation in the standoff between the West and Russia over Ukraine risks holding back the recovery and stoking prices if energy supplies are hampered.

The euro-area economy isn't starting 2022 on a strong footing, expanding by just 0.3% in the final quarter of last year. Germany, meanwhile, is on the brink of a second recession since the pandemic began after a surprisingly sharp contraction.

On Thursday, policy makers also took the following decisions:

The deposit rate remains at -0.5%
Interest rates won't rise until projections show inflation sustainably at 2% and underlying price pressures are consistent with that goal
APP will be raised to 40 billion euros/month in second quarter, 30 billion euros/month in third quarter, and 20 billion euros/month from October onwards
Special conditions on long-term loans to banks will end in June