ECB doves disheartened by plans to hasten pace of rate rises

Dovish rate-setters at the European Central Bank are leaving their meeting in Amsterdam disgruntled, after record inflation forced them into making concessions on the pace of interest rate rises over the coming months.

“My impression is everybody lost,” one dovish governing council member said of Thursday’s decision. That saw the ECB signalling it was likely to raise its benchmark deposit rate above zero by the autumn — faster than investors expected — to tackle inflation which at 8.1 per cent is now four times the bank’s 2 per cent target.

The council member said the ECB had achieved the worst possible outcome; government borrowing costs went higher, particularly for weaker southern European countries like Italy, while the euro fell almost 1 per cent against the dollar — fuelling more inflationary pressure by raising the cost of imports. The dovish rate-setter added: “This is not what you want.”

The council’s more upbeat hawks see things differently. “It went well. We finally decided to take action on inflation, so I am very satisfied,” said one rate-setter from this camp.

In fact the deal, which was drawn up by ECB chief economist Philip Lane, meant both sides made concessions.

After dining together on Wednesday evening beneath Rembrandt’s painting of The Night Watch in the Rijksmuseum with the Dutch king and queen, Willem-Alexander and Máxima, prime minister Mark Rutte and finance minister Sigrid Kaag, the council gathered again on Thursday to unanimously support the compromise.

The hawks agreed to back down on their push for the central bank to end its eight-year experiment with negative rates in one go next month via an aggressive half percentage point increase in the deposit rate from a current level of minus 0.5 per cent.

Instead, the ECB said it intended to raise rates by 25 basis points in July. But in return the hawks won a commitment that the ECB would raise rates by “a larger increment” in September, as long as the inflation outlook “persists or deteriorates”. Given that inflationary pressures are likely to keep rising for several months, most investors assume this means a 50bp rate rise is highly likely in three months’ time.

In a sign of how the hawks now feel more in the ascendancy, several said they still had not entirely given up on the possibility of a 50bp rise in July, especially if eurozone inflation overshoots expectations again when new data comes out at the end of this month. The ECB declined to comment.

Germany’s central bank underlined the hawkish shift by announcing on Friday it had more than doubled its forecast for inflation in the country this year from its December projection to 7.75 per cent – the highest level in at least 40 years. It also slashed its 2022 growth forecast for Germany by more than half to 1.9 per cent and said inflation would remain above growth for the next three years.

“Euro area inflation rates won’t fall by themselves,” said Bundesbank president Joachim Nagel, stressing the need for “resolute action”.

Government borrowing costs rose in response to this week’s hawkish shift. Germany’s 10-year bond yield climbed 0.08 percentage points to 1.43 per cent. Riskier debt sold off more sharply, with Italy’s 10-year yield up 0.24 percentage points to 3.61 per cent.

Line chart of spread between Italian and German 10-year government bond yields widens showing Mind the gap

Some investors were disappointed that the ECB did not provide a clearer commitment to launching a new bond-buying scheme if needed to avert a fresh debt crisis among highly indebted southern European countries, such as Italy.

The issue was discussed at this week’s meeting and council members agreed that ECB president Christine Lagarde would use her press conference on Thursday to emphasise their willingness to launch a new instrument at short notice if needed to “fight fragmentation” in eurozone bond markets, according to one person involved in the discussions.

A severe “fragmentation” in member states’ borrowing costs would mark a return to the days before the ECB began buying bonds in 2014 — a time when the threat of a debt crisis in more vulnerable member states risked triggering a break-up of the currency area.

But most council members agreed there was no point trying to design a new instrument to tackle this risk until it materialised, because it could be blocked by the ECB’s own lawyers for not being “proportionate” or attract a challenge in Germany’s constitutional court.

Battle lines are already being drawn over the next contentious issue: how soon to start shrinking the ECB’s balance sheet. At the moment, the plan is to keep on reinvesting the proceeds of its €4.9tn portfolio of securities as they mature. The hawks want that to stop sooner rather than later, following the lead set by the US Federal Reserve and Bank of England.

Analysts say it will become increasingly difficult for the ECB justify keeping its balance sheet static when it is also trying to tame record inflation by raising rates. Katharina Utermöhl, senior Europe economist at Allianz, said that, if high inflation warranted rate rises, then “a shortening of the reinvestment horizon” also appeared necessary.

Some council members think that as the ECB raises its deposit rate, it risks lifting short-term borrowing costs above long-term rates, especially if it keeps longer-term yields suppressed by reinvesting the proceeds of maturing bonds.

This could create an inverted yield curve, with short-term borrowing costs higher than longer-term ones, making life difficult for banks that aim to borrow short and lend long — and earn a profit on the difference. The risk of yield curve inversion could put pressure on the ECB to start shrinking its balance sheet even before the end of this year.

But other rate-setters said there would be many factors determining when to start shrinking the ECB balance sheet — a process known as quantitative tightening — including the pace of inflation, the state of the economy and overall government debt levels. “I don’t think we will see this happen any time soon,” said the dovish council member.

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