The European Central Bank may need to raise interest rates so much that they dampen growth as it fights sky-high inflation, while any runoff in the ECB’s bond holdings must be “measured and predictable,” its chief Christine Lagarde said on Friday.
The ECB has raised rates by an unprecedented 200 basis points since July and flagged yet more policy tightening via rate hikes, the reduction of its €5-trillion ($5.2-trillion) debt holdings and more expensive bank funding.
“We expect to raise rates further – and withdrawing accommodation may not be enough,” Ms. Lagarde said in a speech at a conference.
“Interest rates are, and will remain, the main tool for adjusting our policy stance,” she said. “Acknowledging that interest rates remain the most effective tool for shaping our policy stance, it is appropriate that the balance sheet is normalized in a measured and predictable way.”
The comments suggest the euro zone’s central bank aims to shrink its €3.3-trillion Asset Purchase Programme of mostly government debt passively, possibly putting it on auto pilot instead of using it to actively manage the ECB’s policy stance.
At 1.5 per cent, the ECB’s deposit rate is not far from the so-called neutral rate, where the bank is neither stimulating nor holding back growth. Most estimates of the neutral rate are between 1.5 per cent and 2 per cent, suggesting that after an expected December hike “accommodation” will have been removed.
The problem is that inflation, running at 10.6 per cent, is far above the ECB’s 2-per-cent target and even a recession, now almost certain over the winter months, is unlikely to ease price pressures enough to let the ECB step off the brakes.
In what may be a relief for the ECB, a key German union agreed to a modest wage deal overnight, indicating that rapid inflation has yet to set off a wage-price spiral.
IG Metall, Germany’s largest trade union, struck a deal for a 5.2-per-cent wage increase next year and a 3.3-per-cent rise in 2024 in Baden-Wuerttemberg, averting the threat of broader strikes.
The deal, which also includes a €3,000 one-off payment but fell short of an 8-per-cent wage demand, is likely to set a benchmark for millions of workers in other German states.
“It’s not good news for the ECB, but we would argue that it’s not bad news either,” Pictet Wealth Management economist Frederik Ducrozet said.
“With inflation running at double-digit rates in Germany, this is not the definition of a wage-price spiral.”
Investors are now split between pricing in a 50 or 75 basis-point ECB rate hike in December after back-to-back 75 basis-point moves. They see the reduction – known as quantitative tightening – of its holdings of bonds, mostly issued by euro zone governments, starting in the first half of 2023.
The ECB will outline plans for balance sheet reduction in December and the process is expected to start with the bank allowing some, but not all, bond holdings to expire.
“The ECB will ensure that a phase of high inflation does not feed into inflation expectations, allowing too-high inflation to become entrenched,” Ms. Lagarde said.