MNI INTERVIEW: ECB Likely To Be Forced To Support Bond Markets

The European Central Bank is likely to have to push interest rates substantially above 4% and will be forced to intervene to support some sovereign bond markets as it reduces its balance sheet, an advisor to the German government told MNI.

The ECB is widely expected to raise its deposit rate by 50 basis points to 3% next week, and strengthening core inflation means chances of another half-point hike in May are rising, Gabriel Felbermayr said in an interview, noting that real interest rates were still stuck “way into negative territory.”

It is becoming increasingly likely that the ECB may need to hike “substantially” above 4% in order to preserve the credibility of its commitment to its 2% inflation mandate, which recent euro depreciation would suggest is already being questioned by markets, said Felbermayr, a member of the Scientific Advisory Board of the German Federal Ministry for Economic Affairs and Energy as well as being director of the Austrian Institute for Economic Research (WIFO). (See MNI SOURCES: 100bp Gap Between Hawk-Dove ECB Peak Rates)

“The costs of going far beyond 4% would probably be a recession, particularly in some member states,” he said, adding that the ECB may also be forced to accelerate quantitative tightening to reduce its EUR700 billion balance sheet should core inflation become more entrenched.

“The unpleasant truth is that if the recession is not happening but inflation remains high, that is a signal that monetary policy is not doing enough,” he said. “I don’t like it, but if we think we need demand to fall substantially for prices to go down then probably using QT will be on the policy agenda. But it's certainly more risky.”

BOND MARKET RISKS

One risk would be of a sell-off in the debt of fiscally weaker states, prompting the ECB to buy their bonds via its new and so-far-untested Transmission Protection Instrument. While the TPI’s activation is conditional upon compliance with European Union fiscal guidelines, Felbermayr said these were becoming more difficult to determine at a time when the bloc is locked in difficult negotiations to overhaul Stability and Growth Pact rules on public debt. (See MNI INTERVIEW: ECB Would Have To Act Fast With Crisis Tool)

“Regardless of whether the fiscal rules are adjusted or not, because of the inflationary processes being so persistent, and the weakness of the interest rate channels, I think it is almost inevitable that we will see more QT, and then we will see the TPI being put in place with certain countries,” he said.

“One could even say: it doesn't really matter what fiscal policy does, because the ECB will probably be pushed into using quantitative tightening by its mandate, and then it will need to apply the TPI.”

In the meantime, the ECB’s decision to run off an initial average EUR15 billion in bonds per month represents “good logic,” said Felbermayr.

Wage growth - identified by ECB chief economist Philip Lane this week as a key driver of underlying inflation – is likely to follow upward price pressures closely in some sectors, he said, and a weaker euro and China’s reopening could further fuel price pressure.