MNI INTERVIEW: ECB To Hike More Than Expected, Rattle Markets

The European Central Bank may need to raise rates further and faster than even policymakers realise to control inflation, a European Parliament advisor told MNI, warning of “blood” as investors and borrowers who have underestimated the scale of likely tightening are caught out.

While markets are pricing in an ECB deposit rate of about 3% by September 2023, this is still well below the 4.6% peak anticipated by the Federal Reserve in its summary of economic projections dot plot, noted Charles Wyplosz, professor emeritus at the Graduate Institute, Geneva, adding that the ECB itself appears not to recognise that rates will have to go up “much further”.

Policymakers raised rates by 75 basis points in September, but while they have indicated they will continue to frontload tightening, they are unlikely to be able to slow the pace of increases soon, Wyplosz said in an interview. (See MNI SOURCES: More ECB Policymakers See Restrictive Rates)

“I wouldn’t expect to get any encouraging readings on inflation before the end of [this] year,” he said. ”I'd be surprised if inflation is tamed so early.”

Markets and borrowers have been guilty of complacency ahead of central bank tightening, he said, taking on excessive risk.

“One reason for concern is that market expectations of how high interest rates will be have been significantly behind the curve all along, and they are still right now, which means that in my mind there is a lot of wishful thinking,” he said. “They will be surprised, and where they are surprised there will be some blood somewhere.”

TPI TO BE TESTED

And yet a rise in corporate defaults should not unduly trouble the ECB unless it leads to systemic instability.

“Nobody's going to care too much if a number of companies go belly up. The problem is, if a number of important participants go belly up, this may in turn hurt the commercial banks. That’s where I worry very much,” Wyplosz said.

The ECB’s new Transmission Protection Instrument, which would suppress any blowout in spreads by buying peripheral bonds but has yet to be deployed, is also likely to be put to the test, said Wyplosz, whose research paper on TPI was presented to the European Parliament ahead of last month’s ECON Committee grilling of ECB president Christine Lagarde. While eligibility for TPI assistance is linked to compliance with EU fiscal rules, the mechanism may still make it harder for the ECB to reduce the size of its balance sheet, he said.

The ECB will take the view that "e are on the path of raising the interest rate, and we can go pretty far up pretty quickly. We don't want to be stopped by another financial crisis," according to Wyplosz.