MNI INTERVIEW: ECB May Hike Above 4% - Ex-Stability Head

Eurozone interest rates may go above 4% as inflation stays high for longer than expected, former senior European Central Bank official Ignazio Angeloni told MNI

September’s Eurosystem projections putting 2022 inflation at 8.1% and 5.5% next year are more or less correct in the absence of any further shocks, Angeloni said in an interview, but cost pressures will remain elevated for two to three years, as the initial energy and food price shocks slowly trickle down through the price and wage chain (see MNI INTERVIEW: ECB Hikes May Be Closer Than Thought).

Markets are currently pricing in a terminal rate for the ECB’s deposit facility of around 3% by September 2023, based in part on the assumption that the neutral or equilibrium rate is between 1 and 2%. But this is a poor indicator of where rates will end up, said Angeloni, who served as head of the ECB’s Financial Stability and Macroprudential Policy department.

Short- to -medium term expected inflation rates of around 3-4% are more relevant, Angeloni said, since the eurozone financial system is predominantly bank-based. “This means the neutral rate in nominal terms is still very far from where we see short-term market rates now. The terminal rate will need to go higher than that to ensure the right stance.”

QUANTITATIVE TIGHTENING

How and when the ECB might use its balance sheet to tighten monetary conditions is closely linked to the issue of its remuneration of bank’s reserves, which will tend to fall as investment flows are attracted by higher yields on government and corporate securities, he said.

“I would expect that quantitative tightening is not pushed by the central bank, but will happen to an extent automatically. The ECB will use its portfolio to accommodate an increased demand of securities by the private sector. For that to happen, the central bank should resist temptation or pressure from banks to increase the remuneration of reserves.”

Investors attempting to anticipate when the ECB might deploy its new Transmission Protection Instrument, which is mean to suppress any excessive rise in eurozone spreads, seem to be mistakenly focussing on the yield differences between 10-year bonds, said Angeloni, noting that while the 10-year Germany-Italy spread is almost 250bps, the two-year gap is only just over 100bps.

The creation of the TPI was a mistake, argues Angeloni, now Senior Fellow at the Leibniz Institute SAFE , who said that it has placed the ECB in the invidious position of certifying the sustainability of government finances at the same time as it raises rates.

ITALY STILL THE PROBLEM

“Everybody expects the ECB to intervene first, the [European Stability Mechanism] is pushed out of the picture,” he said. “Constructive ambiguity may help now, but eventually, if the instrument is to be used, those questions will need to be answered in words or deeds. And that will be a precedent for the future.”

Italy remains the eurozone’s only “real problem” in terms of fiscal sustainability, he said, pointing to continued uncertainty over the economic direction of prime-minister-in-waiting Giorgia Meloni’s incoming far-right government.

While eurozone growth was likely be worse than the -0.5% expected by the International Monetary Fund, it should be better than the -2% to -3% anticipated by a minority of forecasters, Angeloni said. Yet even a deeper downturn may not be enough to halt ECB rate rises without clear signs of inflation approaching the 2% target.

On Friday ECB vice president Luis de Guindos said September's downside growth scenario - according to which the economy will shrink by almost 1% next year - is coming closer to being the baseline.

This is a “delicate moment” for European financial stability - especially in shadow banking, Angeloni said, with large amounts of risk built up during the QE period and the threat of an increasingly illiquid securities market bringing central banks’ status as lender of last resort into sharper focus.

“In a way, this is what happened in the UK a few days ago, with some pension funds engaging in fire sales and having difficulties in this operation. Under those circumstances, the central bank has to intervene.”