The Governing Council maintains a hawkish course
The lady is a hawk
When Christine Lagarde took office, she added the owl of Minerva to the ornithology of the central bank world. She wanted to be perceived as the guardian of wisdom. Now she has deemed it wise to change into a hawk. In December, whilst fending off the demand to raise key interest rates by 75 basis points, she has, to everyone’s surprise, announced further hikes of 50 basis points each. And now she is trying to silence the calls arising from within the Governing Council for a shortening of the interest rate steps. “Stay the course” is her mantra for monetary-policy purposes.
50 basis points are set for 2 February. No one in the ECB Governing Council will want to shake that. But in mid-March, when a new projection is available, the doves in the Council will question the promise made to the hawks back in December to accept another 50-point move. They hope that the new staff estimates will show a faster decline in the core rate so that their warnings not to overtighten the interest rate screw could be heard again.
Without committing to concrete figures, the French governor, who doesn’t mind being seen as tipping the scales, has described the future course. By the summer, an interest rate level is to be reached that the Governing Council considers appropriate to push the inflation rate down to 2 per cent in the medium term. But which interest rate steps are necessary until then? And when is summer? At least one thing has been made clear by François Villeroy: once the target level has been reached, it will go sideways for quite a while. Market players would be wise not to bet on interest rate cuts as early as by the end of this year or even in the coming year.
What we would consider necessary
Attention, here comes a typically German hawkish view. If you are allergic to it, please skip straight to the next section.
With a core inflation rate of 5 per cent that shows little sign of going back voluntarily, more than two more 50-basis-point steps would be needed to reach positive real interest rates, in our view. And without lifting interest rates into positive territory, the fight against inflation is unlikely to succeed. So if the Governing Council really wants to push inflation down to 2 per cent by 2025, it should define summer as July and choose the following sequence of steps at the five monetary policy meetings to be held between now and then: 50-50-50-25-25. This would put the deposit rate at 4 per cent in summer and thus close to the core inflation rate to be expected then. If one then strictly followed Villeroy’s course, a slow decline in the core rate would open up the chance of a positive real interest rate for 2024. And a year later, the Governing Council could declare victory over inflation.
To take this course, however, the Governing Council would have to brush aside all the manifold, well known concerns: In Germany, the wind energy sector and real estate investors are complaining about rising interest rates; in Italy, small and mediumsized entrepreneurs and even the defence minister are strongly voicing their concerns.
We would not want to rule out that the Council will dare to take this hawkish course, especially if the economy (and inflation) proves to be robust. However, its probability of coming true is not very high.
What the Governing Council is likely to do
We expect the arguments of those who warn about overtightening the screw, stalling the economy and torpedoing future investments to be heard more in the Council again in the coming months. Already in March, the hawks will have to fight to keep the upper hand. In the scenario we consider most likely, summer is already in June and the hike cycle ends after four rate decisions. The path is then: 50-50-25-25, taking the deposit rate to 3.5 per cent, where it will remain for an extended period.
In this scenario, it could become apparent in 2024 that the central bank has done too little to push inflation significantly below three per cent. In the medium term, we could find ourselves in a world where both the relevant central bank interest rate and the inflation rate show a three before the decimal point.
The case for such a scenario is that fundamental factors such as the enormous resource re-quirements for the green transition, the structural increase in the price of energy, the shortage of skilled labour, the shifting of supply chains, the newly discovered need for defence and soon also the enormous burdens of the reconstruction of Ukraine will ensure continued price pres-sure at all levels of production and on the labour market.
And what if the Council did become a dovecote again?
When Mario Draghi headed the Council, he seemed to preside over a gently cooing dovecote – at least for the majority. Under Christine Lagarde, it took a long time for the doves to recognise the signs of the times and grow hawk feathers – only to get rid of them at the first opportunity.
In this scenario, the 50-point steps are already over in March and it is already summer in May. The path is therefore: 50-25-25. The deposit rate would then be 3 per cent in May.
The argument here would be that the epoch of low inflation has not fundamentally come to an end but has only been paused by a short-term energy price shock.
We do not think this is very plausible and would not expect the Governing Council to agree with this view.
Wouldn’t it make sense to accelerate the balance sheet reduction?
From March to June, the Eurosystem will continue to reinvest about half of the maturing bonds in the APP and – not to be forgotten – all redemptions in the PEPP. From hints given in Council members statements, it can be concluded that from July onwards, there will probably be an end to the reinvestment of maturing bonds in the APP. This pre-drawn path takes into account the record issuance of government bonds expected in the first half of 2023. Bundesbank board member Sabine Mauderer specifically pointed this out in the FT.
We believe that the ECB Governing Council should think about using its degrees of freedom with more confidence: The risk-free 10-year interest rate, which is marked by the Bund yield, hovers around a meagre 2.2 per cent and the Italian spread is not worrying with 180 basis points. And there are strong reasons for actively reducing the size of the balance sheet. Central bank veteran Ignazio Angeloni recently explained it in a guest article published by OMFIF.
By actively doing so, the Governing Council could go a long way in restoring the classical central bank regime with tight liquidity supply to the banking system and a main refinancing rate having more importance again in monetary policymaking. It could thus gain back the necessary tools – and with them authority – to get inflation under control even in an adverse scenario.
At the same time, by actively reducing its balance sheet, the ECB could visibly detach itself from fiscal policy, demonstrate its independence and remove the wrong incentives coming along with rampant bond purchases.
If the bird of wisdom, the owl, is to be the model, then the central bank would be well advised to leave the financing of the states to the markets again and to transfer the responsibility for the cohesion of the currency area to the elected governments and parliaments.
Do markets get it wrong?
Market participants still bet on a not so steep rise in policy rates and a target rate below our middle path scenario. In addition, many expect rates to decline again only a few months after target being reached. Do they not hear or believe what Christine Lagarde, François Villeroy or Klaas Knot clearly indicate? Rates will stay higher for longer. In the December account of the governing council one can read an interesting sentence. “A large number” of the members expressed their view that “prevailing market expectations and financial conditions were plainly inconsistent with a timely return to the ECB’s 2 percent inflation target.” Be prepared to read this again in the next account.
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