ECB Preview: Difficult trade-offs intensify

With regards to future interest rate hikes, the current guidance does build in optionality based on the way the outlook develops. The ECB has signalled that the September move would be a 50bp step ‘If the medium-term inflation outlook persists or deteriorates’. Whereas ‘based on the current assessment’ after September it anticipates ‘a gradual but sustained path of further increases in interest rates’. This implies 25bp steps, but this depends on ‘the incoming data and how it assesses inflation to develop in the medium term’.

Since the June meeting, the likelihood of further significant reductions in gas supply has increased. Last month, the ECB presented an alternative scenario, which assumed a complete cut in Russian energy exports to the euro area. This scenario implied even more difficult trade-offs for the ECB, as inflation over the next year or so would be higher, while the economy would enter a recession. On balance, we think that such a scenario would imply less interest rate hikes than its base case – and indeed current market pricing - for two reasons. First of all, headline inflation would be lower and below target over the medium term. Second, the weakness in the economy and much higher unemployment would significantly reduce the risks of second round effects on inflation. It is likely too early at this meeting to expect the ECB to change its expectations or signalling on the future path of interest rates as there remains a lot of uncertainty on the outlook for gas supply. So despite rising recession risks, we think the central bank will stick to the path it signalled in June for now.

Meanwhile, the ECB will likely announce the new anti-fragmentation tool, which has apparently been named the ‘Transmission Protection Mechanism’. We expect the new tool to be an asset purchase programme focused on peripheral countries. We doubt that the ECB will be specific about the parts of the curve it can purchase, the total targeted amounts or the conditionality (which will likely be of a token nature). However, we do think it is likely that the programme will be ‘sterilised’ so that it does not interfere with the monetary policy stance, which could ultimately limit its size. Indeed, this demonstrates that it is much more difficult to fight fragmentation when normalising than when easing policy.

In addition, we think the ECB will present the new tool as a back-stop rather that something it intends to implement right away. Indeed, interventions under the Securities Markets Programme, which we think is the best historical analogue to the new tool, were at levels of spreads around the 300bp area. We judge that doubts about the scale of the tool, as well as uncertainty about the conditions under which it could be implemented, could prove to be disappointing to financial markets.

The rise in Italian political risk could add to the complexity of the ECB’s position. Italy’s Prime Minister Mario Draghi could potentially resign on the day before the Governing Council’s announcement. Although we think that the ECB would ultimately chose to fight fragmentation even if its source appeared to be political risk, such a situation could cause some division in the Council, leading to delayed and possibly less decisive action.