ECB Review - Not the end, but maybe the beginning of the end
ECB less certain on extent of further rate hikes - The ECB raised its key policy rates by 75bp as expected. It made important changes to the language in its press statement. Although the tightening bias remained, it is now no longer signalling the likelihood of a string of further rate hikes. Although the Governing Council ‘expects to raise interest rates further’ it ‘will base the future policy rate path on the evolving outlook for inflation and the economy’. This is a change from previous guidance that it expects to raise interest rates further ‘over the next several meetings’. This reflects that the ECB now judges that it has ‘made substantial progress in withdrawing monetary policy accommodation’.
While this was not mentioned in the statement, the deterioration of the economic outlook may have also played a role here. ECB President Christine Lagarde sounded noticeably more downbeat in setting out the Governing Council’s view of the economic situation. The ECB will make an official re-assessment of the situation at its next forecasting round in December. She noted that the ECB would take three factors into account (a) the future path of inflation, taking into account the increased likelihood of recession (b) the significant policy rate hikes so far (c) the lags in the transmission of monetary policy.
The ECB President stressed that the ECB did not have a pre-determined terminal interest rate in mind but would raise rates to a level that would ensure that inflation would return to 2% over the medium term. In the September forecast round, the ECB projected inflation at the end of 2024 at 2.2%, on the basis of a policy rate around 2%. That would imply that the policy rate needs to go slightly above 2%. However, that also assumed that the eurozone economy would expand by 0.9% next year, where as we think average economic growth will be around two percentage points lower. Given this and the sharp further tightening of financial and bank lending conditions since then, we remain of the view that the deposit rate will peak at 2%, most likely in December.
Changes to TLTRO terms - The ECB announced that it was changing the terms and conditions of TLTRO III. In particular, from 23 November 2022 until the maturity date or early repayment date of each respective outstanding TLTRO III operation, the interest rate on TLTRO III operations will be indexed to the average applicable key ECB interest rates over this period. This compares to the average over the life of the loan previously, so this represents a major jump in the lending rates. The ECB hopes that this will trigger (a) a better transmission of its rate hikes into bank lending rates (b) early TLTRO repayments so that its balance sheet shrinks more quickly (c) release of collateral on early repayment to help alleviate scarcity. Indeed, three additional voluntary early repayment dates will be introduced to provide TLTRO III participants with additional opportunities to partly, or fully, repay their respective TLTRO III borrowings before their maturity.
QT discussion in December - Another important signal from the press conference is that the ECB will discuss the main principles of the shrinking of its portfolio of securities in December. One important clarification made was that this would apply at this stage to the APP, and hence not the PEPP. It seems that such a process would unlikely be implemented until next year, perhaps in March. The ECB would likely slow and eventually end reinvestments under such a process. Ending APP re-investments would likely shrink the ECB’s balance sheet by a little below EUR 30bn a month, so it would be a very slow process. Indeed, the repayment of TLTROs will be a much more significant driver of balance sheet reduction next year.