Francesco Canepa & Balazs Coranyi

FRANKFURT, Reuters – On Thursday the European Central Bank will end years of stimulation and signal a series of rate increases to combat surging inflation. Markets are left guessing at the scale and pace of the policy tightening.

The ECB already made a number of steps to prevent inflation from reaching record levels at 8.1%.

The details are still elusive as it is difficult to predict inflation. This suggests that the ECB may only announce its first steps Thursday, but will retain plenty of flexibility down the road.

It seems certain that the ECB will stop its Asset Purchase Programme, end it at the end this month and promise a rate rise on July 21. This will signal that the second quarter’s deposit rate will not be in negative territory.

Christine Lagarde of the ECB emphasizes flexibility, and optionality.

The bank is indicating a preference of 25-basis point hikes. However, the impact of the surge in oil prices on prices may change this in just weeks. A small number of policymakers believe that the need for a larger rise is still possible.

The ECB has released new economic projections that support this argument. These show that the inflation target for 19 of the euro countries is likely to be met through 2024. It will also indicate four consecutive years with overshooting.

Kamil Kovar (Moody’s Analytics Senior Economist) stated, “The probability of a 50 basis-point increase is rising by day.”

We currently consider a 50-basis point hike in July possible, but not likely. A September 50-basis point hike is possible, but unlikely.

He said that it was possible for the bank to resort to several 50-basis point hikes.

Markets have priced in 135 basis point rate rises before the year ends, an increase at all meetings starting July and some moves exceeding 25 basis points.

The ECB is now in a precarious position after Lagarde had said it was unlikely that they would increase their rates this year.

If she doesn’t pay attention to markets, then even more drastic tightening could be price in. This would unnecessarily push up borrowing costs. However, if she insists on her position, she might signify a commitment that will be abandoned in weeks.

The ECB’s rate increase would be its first in more than a decade, but it still trails most of its international peers like the U.S. Federal Reserve or the Bank of England. These global peers have raised aggressively and promised even more.

Bank of America (NYSE 🙂 stated in a note that “The hawkish turn has begun.” We expect that the ECB will open the door to 50 basis points in September and July, signalling that the end of negative rates is imminent during the third quarter.

WHERE IS IT ENDING?

Although the beginning of tightening policy is set now, it’s not clear when the final point will be.

Lagarde stated that rates must move toward the neutral level at which the ECB does not simulate nor hold back growth. This level, however, is not clearly defined and cannot be observed so investors are left to guess how far they want to go.

Holger Schmieding from Berenberg, economist said that the neutral rate is around 2.2%.

“We anticipate the ECB’s principal refinance rate – at 0.0% – to attain this level in mid-2024, after three rate rises of 25 base points in 2022 and three more such moves 2023. Two further rate increases were made in 2023.

Although the ECB has traditionally used the benchmark rate as the refinance rate, the ECB has been using the rate at its overnight bank deposit facilities for banks for most of the past decade to determine its main policy rate. Banks have accumulated hundreds of millions of euro worth of liquidity excess.

A second question concerns how the ECB will deal with the differing borrowing costs among its member states.

Italy, Spain, and Greece are among the countries with higher debt levels. The ECB has had to adjust its monetary policy, which is not universal.

The ECB had promised it would fight “unwarranted fracturement”, but hasn’t defined it yet and it has not stated what actions it would take.

These points could be clarified by Lagarde, but it is not likely that she will announce a particular tool Thursday. Instead, Lagarde emphasizes the ECB’s flexibility and willingness to respond quickly to market turmoil.