MNI SOURCES: Rates/QT Trade-Off Central To Next ECB Decision

The size of the European Central Bank’s rate hike next week will feed into talks on the timing of quantitative tightening, with hawks likely to press for a faster start to the ECB’s balance-sheet unwind in return for agreeing to an increase of no more than 50 basis points, Eurosystem officials told MNI.

While officials agreed it was difficult to calculate any equivalence between the tightening effects of rate hikes and of ceasing to reinvest a portion of maturing Asset Purchase Programme securities, several told MNI that the two issues were bound to be linked, with some hawks looking for a 75-basis-point hike.

“Of course there is a tradeoff. Adjusting the balance sheet and raising or lowering rates are two actions that have monetary policy implications,” one official said. “We have to set a pace for QT and somehow, we have to measure it and keep pace with the rate hikes. If we go up faster or down faster we have to adjust the QT rhythm.”

Other officials denied any connection between the two monetary policy tools.

The ECB is also aware that quantitative tightening is necessary in order to allow longer-term yields to rise as monetary policy normalises, avoiding the danger that raising interest rates will invert the yield curve. The ECB has already said that it will announce a framework for QT in December.

“The tradeoff on the QT is when you start it,” another official said, saying that one deal could be. “Seventy-five in December in exchange for starting it after the peak rate.”

QUICKER QT, SMALLER HIKE

An alternative would be a quicker start to QT, close to the end of the first quarter, and keeping the hike to 50, which sources said seemed the most likely option. One official from a national central bank with a publicly hawkish stance agreed that this could be part of a consensual deal. (See MNI SOURCES: ECB Weighs 50 In December, Hawks To The Fore)

“It could be. [ECB President Christine] Lagarde for sure will go for a unanimous decision,” the official said. ”It depends what they plan to do going forward. If they say 75 in December and 25 in February or 50 in December and 50 in February it’s the same result.”

Another factor will be the pace of banks’ repayments of cheap Targeted Longer-Term Refinancing Operations Loans, which will also contribute to tightening monetary conditions. Eurozone banks repaid EUR500 billion in TLTROs in December, including maturities of EUR52 billion, taking outstanding loans under the facility to almost EUR1.4 trillion. More maturities and repayments could mean TLTROs shave around EUR1.5 trillion off the ECB’s roughly EUR8 trillion balance sheet by the summer.

While ECB Chief Economist Philip Lane says eurozone inflation looks close to its peak at 10%, uncertainty over possible energy spikes and high levels of underlying price rises mean the rate cycle needs to continue higher. A 50-basis-point hike in December would take the deposit rate to 2.5%, close to where some officials consider to be the neutral level, though others, such as Belgium’s Pierre Wunsch, see that as over 3%.

INFLATION PROJECTIONS

Markets, which are pricing in an ECB cycle rate peak of around 2.8% by mid-year, appear to be broadly correct in their assumptions, another official said. With neutral at about 2.25% and headline and core inflation still well above target, restrictive levels of rates will soon be necessary, said the official, who expected a 50-point hike next week.

“We still see another 50-basis-point hike early in 2023, with the pace slowing to a further two 25-basis-point hikes over meetings through late summer, although on a less mechanical implementation,” the official said, adding that December’s macroeconomic projections could show inflation easing to near 2% at the end of the three-year forecast horizon. Any higher than 2%, though, could provide ammunition for continued tightening.

Quantitative tightening is likely to start with reinvestments cut back to 75% or 80% of maturing APP bonds, the official said.

“I think in December we announce the principles behind a gradual reduction of the bonds held on the balance sheet, while in February there could be a more detailed timetable that will start in late Q1 or early Q2,” he said. “But the timetable could easily be kicked up to December, although overall it may not change the actual timings of a start.”

An ECB spokesperson declined to comment.