MNI SOURCES: More ECB Policymakers See Restrictive Rates

More European Central Bank policymakers are becoming convinced that the benchmark interest rate will need to move to a restrictive setting to contain inflation, although there is no clear agreement amongst Governing Council members as to the neutral level of interest rates and many stress extreme uncertainty, senior Eurosystem sources have told MNI.

Market expectations, which are for the benchmark ECB deposit rate to rise from 0.75% to a peak just below 3% in June 2023, are “not far-fetched”, according to one official, though he noted that it was still too early to say whether rates would rise by another 75 or 50 basis points in October. National central bank models suggest similar scenarios, and point to a terminal rate that is likely to be in restrictive territory, higher than the neutral rate of interest.

However, extreme economic uncertainty also means that estimates of both the terminal rate and the timings could change quickly, so the peak of the rate cycle has yet to be seriously debated in the Governing Council, officials said. Another official observed that the notion of the neutral rate, widely seen as somewhere between 1% and 2%, was more useful in more predictable economic environments.

On Thursday, Bank of Spain Governor Pablo Hernandez de Cos said he saw rates peaking around 2.25% or 2.5% in late Q1 2023 -- a level which he said would be above most estimates for neutral and therefore restrictive, albeit below current market estimates.

Other sources agreed that restrictive levels were possible.

“Further hikes in coming months, over several meetings as the president has hinted, will undoubtedly take us to -- or closer to – neutral,” a Eurosystem source said. “When we get there, that may not be 'job done'. We may have to go further, move policy into a restrictive stance.”

NEUTRAL LEVEL UNCERTAIN

But the source also stressed the uncertainty of estimating appropriate levels of rates.

“It is easier for us to talk about neutral and restrictive levels, as it hides current disagreement over what those terms actually mean in practice, in real terms,” the official said.

“First we will need to take stock when we arrive at a perceived neutral level. Then with our ongoing meeting-by-meeting approach to policymaking, we will decide whether we need to go further depending on the inflation outlook.”

Another official was also cautious.

“We are totally comfortable ongoing to neutral, there is no reason to be stepping on the gas right now. Going beyond that is an open question,” one said. He pointed to volatility in UK gilt markets.

“This is a warning to us all, don’t do anything stupid - markets are volatile and stupid actions have consequences,” the source said.

INFLATION EXPECTATIONS

The gradual move amongst policymakers towards a more restrictive policy in coming months is in tune with market thinking – particularly if the neutral rate is around 2%.

De Cos’s estimate of the terminal rate was based on an assumption that the ECB will maintain its balance sheet at its current size, as reinvestments of its bond holdings continue. A reduction of the balance sheet would mean a lower terminal rate.

Whatever the terminal rate, the third source said internal ECB debate currently was more focussed on how to deal with inflation expectations.

“What kind of increase should we put in now to try to bolster the credibility of our mandate and avoid de-anchoring expectations, and slow down demand? Making sure expectations are anchored. And here views can differ,” he said.

An ECB spokesperson declined to comment.