ECB’s new tool gives it green light for faster normalisation

ECB hikes by 50bp but signals terminal rate will not necessarily be higher

The ECB raised its policy rates by 50bp following yesterday’s meeting. The increase was bigger than expected by the consensus (+25bp) and financial markets (which only partially priced in the likelihood of a bigger move), but in line with our recently revised call.

The ECB explained that the bigger move than it had signalled earlier was based on the ‘updated assessment of inflation risks’ and reflected its ‘strong commitment to its price stability mandate’. In addition, the move was aimed at ‘strengthening the anchoring of inflation expectations and (…) ensuring that demand conditions adjust to deliver its inflation target in the medium term’. The ECB also felt more confident to normalise at a faster pace, safe in the knowledge that it now had a new tool to fight the potential side effects in terms of fragmentation (see below).

The statement signalled the welcome death of very specific forward guidance. Although the Council still announced that ‘further normalisation of interest rates will be appropriate’, it would now shift to ‘a meeting-by-meeting approach to interest rate decisions’ which would be ‘data-dependent’. As such, the previous guidance that signalled that a 50bp move was likely in September, was no longer valid.

Meanwhile, in the press conference following the decision, President Christine Lagarde noted that the larger initial rate hike (and the pace of subsequent moves) did not impact the eventual destination - specifically the level of the terminal rate. Ms Lagarde was not explicit on where the ECB saw the neutral rate. However, she did reference market measures. The market measure the ECB looks at is the 2y9y forward, which currently sits somewhat above 2%. In addition, other officials have suggested a normal rate is likely around 2%. As we have noted before, we think it is most likely lower than this, while the normalisation cycle could eventually be disrupted by a more severe economic downturn.

TPI seen as a plan B and subject to conditionality

The ECB also announced its new Transmission Protection Instrument (TPI) which aimed ‘to ensure that the monetary policy stance is transmitted smoothly across all euro area countries’. The TPI is an asset purchase programme designed to fight against excessive widening of spreads.

The full details of the programme can be found here, but the key features are:

1. Subject to conditions (see below) the Eurosystem will be able to make secondary market purchases of securities issued in jurisdictions experiencing a deterioration in financing conditions not warranted by country-specific fundamentals.

2. The scale of TPI purchases would depend on the severity of the risks facing monetary policy transmission. Purchases are not restricted ex ante.

3. TPI purchases would be focused on public sector securities with a remaining maturity of between 1-10 years. Purchases of private sector securities could be considered, if appropriate.

4. The Eurosystem will accept the same (pari passu) treatment as private or other creditors.

5. The eligibility criteria include compliance with the EU fiscal framework, absence of severe macroeconomic imbalances, public debt sustainability and sound and sustainable macroeconomic policies.

6. The ECB will avoid potential interference with the appropriate monetary policy stance by addressing the implications of the TPI purchases for the scale of the aggregate Eurosystem monetary policy debt security portfolio, and the amount of excess liquidity. This implies the programme will be sterilised.

7. PEPP reinvestment flexibility will continue to be the first line of defence to counter risks to the transmission mechanism.

The announcement of the TPI did not hugely impress financial markets. Partly this reflects that a lot was already priced in following the Governing Council’s ad-hoc meeting last month, which pre-signalled the announcement. However, market caution may also reflect that the TPI is very much a plan B option, which will not be implemented at the current time (plan A being the PEPP reinvestment skew). In addition, the eligibility criteria may have created some doubts. Although the ECB would not theoretically be restrained from intervening to cap spreads driven higher by political risk, there is the possibility that a future Italian government’s actions may break the fiscal and macroeconomic criteria. Furthermore, even though the ECB has set no ex ante limits to the scale of purchases, the commitment to sterilise their impact may in technical terms limit the scale. Finally, it is worth noting that the TPI would be swimming against the tide. With the economy slowing, policy rates going up, market volatility elevated and political uncertainty in Italy, there are numerous negative drivers for peripheral spreads currently.