MNI INTERVIEW2: End of ECB Negative Rates In Sight- Knot

The European Central Bank is very likely to end its asset purchase programme in the third quarter of this year, the head of the Dutch central bank told MNI, adding that he was comfortable with market pricing of future ECB rate hikes and that the end of negative rates could be in sight.

Risks to both the near- and medium-term inflation outlook are clearly tilted to the upside despite high uncertainty prompted by the war in Ukraine, allowing for monetary policy to move towards normalisation, Klaas Knot said in an interview, in which he also said that the ECB should avoid aggravating the effect of higher oil prices by allowing an excessive depreciation of the euro. (See MNI INTERVIEW2: ECB Should Guard Against Euro Weakening-Knot)

“I’m pretty confident that [the asset purchase programme] will end in Q3,” Knot said. “It would take a fundamental downgrade in the inflation outlook between now and June, because that’s the last moment in which we have to take a decision on Q3, to not stop the APP in Q3, and I don’t see where that would come from.”

MARKET PRICING

Knot said he was “comfortable with current market pricing of lift-off”, which he said implied that the ECB would have no need to adjust the calibration of its tiered deposit rate shielding banks from some of the effect of negative rates. Rates markets are currently pricing in a 47 basis-point increase by the ECB by the end of the year, with 25 by September.

“If such a scenario were to unfold, then my personal view is that there is no need to revisit the discussion on tiering as then the effective end of negative interest rates would be in sight,” he said.

Last week the ECB said gradual upward adjustments to key interest rates would take place “some time” after APP ends. However, mirroring the slow approach taken into negative territory would be unnecessarily cautious, Knot said.

“Each time we went down by 10 basis points we entered uncharted territory. On the way up there is no uncharted territory, so a priori, there is not such a strong rationale to have to go in 10-basis-points baby steps,” he said.

Markets have already proved their ability to withstand a EUR10-billion-a-month reduction in the pace of asset purchases, which contributed to the ECB’s decision at its last meeting to say that it would end APP in the third quarter if data permits, Knot said.

“It’s not so much a tightening of policy, it is more normalisation. It’s withdrawal of this unprecedented amount of stimulus, rather than moving into a contractionary, actively tightening domain,” he said.

HIGH UNCERTAINTY

But he said that the ECB would react if sovereign bond spreads blew out.

“PEPP reinvestments will be our first line of defence,” he said, referring to the ECB’s Pandemic Emergency Purchase Programme. ”If more is needed, then undoubtedly, we will come up with what is needed.”

The Ukraine conflict has injected unusual amounts of uncertainty into the ECB’s projections, he said, but he noted that they did not take into account likely increases in government spending as a result of the war.

“Our starting point was very, very favourable, so we shouldn't dramatise in terms of talking about possible negative growth rates for 2022,” he said. “And, second, our projections do not take into account fiscal policy. We are going to see higher spending on defence, and accelerated investments in renewables because we all want to wean ourselves off Russian gas and oil.”

The ECB’s models have underestimated both growth and inflation since the start of the Covid pandemic, Knot said. While signs of wage increases feeding inflation have yet to appear, he said, pointing to recent data from the Netherlands, the ECB would not have the luxury of waiting to see whether such a spiral occurs.

“The longer higher inflation sticks around, of course the likelihood of second-round effects culminating into higher wage contracts becomes larger and larger. And that likelihood is the relevant magnitude for us to take into account when setting policy,” he said.

Knot praised the “inclusive” leadership style of ECB President Christine Lagarde, who oversaw a unanimous policy decision last week.

“What matters is that at the end of the day we coalesce around a way forward, which is crafted by the chief economist and the president,” he said. “The degree of consensus that we've had in the Governing Council over the last two and a half years has been remarkable.”