MNI INTERVIEW: ECB May Cut Less, Slow Balance Sheet Runoff

European Central Bank easing this year could fall short of market expectations if it chooses instead to slow the pace of its balance sheet reduction in a bid to slow inflation without stifling sluggish economic growth, a leading German government adviser told MNI.

The ECB might choose to cut only three times, below implied market pricing for four or five reductions by December, said Gabriel Felbermayr, Director of the Austrian Institute of Economic Research (WIFO) and a member of the Scientific Advisory Board of the German Federal Ministry of Economics and Energy.

This would tend to keep policy tighter than expected for shorter rates -- the ECB's so-called “best tool” for fighting inflation, which have more bearing on consumer spending -- whereas slowing the balance sheet runoff and so putting less pressure on the longer-end rates which have a greater influence on corporate financing and investment, he said.

TRADE OFF

“If we take a more dynamic perspective, as central bankers do, what we have probably learned from the last few months is that monetary easing will probably happen a little more slowly,” Felbermayr said. “There might be some trade-off between short- and longer-term interest rates.”

With euro area pay expected to grow by 4.6% on average this year - 1.6 percentage points above the level the ECB says is consistent with 2% inflation - monetary policymakers face challenging times ahead.

“Since we're not in the game of saying we want to push inflation to 2% immediately and at any cost, it presents a conundrum for the ECB, “ Felbermayr said. “The return to growth requires nominal wages to pick up substantially, by more than 4%, but from an inflation point of view, anything substantially above 4% is probably too much.”

Firms might absorb a higher share of increased unit labour costs in order to remain competitive, he said, but they may also decide against adjusting prices downward should growth surprise to the upside, making fighting inflation more difficult.

Three rate cuts totalling 75bps this year “would already be something significant,” noted Felbermayr.

“Short-term interest rates may not go down as much as the market expects, but at the same time, the speed at which the balance sheet shrinks could be reduced. It’s not the same thing, but there is some degree of substitutability between the two,” he said. (See MNI SOURCES: ECB Cut Expectations Range From 50-100BP In 2024)

In Austria and Germany, light upticks in unemployment will be partially offset by demographic changes that will keep pay growth “relatively high,” while growing labour union confidence and the costs of decoupling from China will also contribute to inflationary dynamics.

CHINESE DEFLATION

“At present China is exporting some deflation to Europe via cheaper electric vehicles and industrial goods, but that is probably not sustainable. We cannot bank on China’s help in containing our inflation for many years simply because of endogenous adjustments in exchange rates,” Felbermayr said.

Inflation is expected to end the year close to 3% in Germany and 4% in Austria, compared with a euro area average of 2.4%. Eurostat last week cut its 2024 euro area growth forecast from 1.2% to 0.8%. In Austria the outlook was cut 0.7% to 0.6%, while Germany's government is this week expected to announce it sees GDP growing by just 0.2% - down from 1.3% in October.

Even with real pay picking up, Austrian and German consumers are not yet convinced that price growth has slowed meaningfully, Felbermayr said, lowering the chances of a consumption-driven return to growth, and increasing downside risks.

New bond buys under the ECB’s Asset Purchase Programme ended in June 2022, with Pandemic Emergency Purchase Programme reinvestments set to reduce at an average monthly pace of EUR7.5 billion over H2 2024.