How much is too much? That’s the question the European Central Bank will wrestle with at Thursday's monetary policy meeting. While there’s mounting evidence of the euro area slipping into recession, it’s a tight call as to whether the Governing Council will decide one more quarter-point hike in its deposit rate is deemed necessary to further curb inflation.
This week’s meeting features updated forecasts, with most analysts expecting reduced growth expectations but little change to the inflation projections. Euro-area output is likely to contract in the third quarter, and there is scant prospect the rest of the year will be any better, which may do much of the heavy lifting of calming consumer prices.
A hawkish pause, retaining a bias to tighten, would be the most prudent course of action to assess the consequences of the nine-step journey in the ECB's deposit rate from negative 0.5 percent in July last year to the current 3.75 percent. Policymakers can still emphasise that a subsequent hike is possible later this year, and there are tools other than interest rates that the ECB can wield to maintain a tight monetary stance. A further unwind of its quantitative easing bond portfolio is possible, along with other measures to reduce its swollen balance sheet.
What’s clear is that dire economic data has been coming thick and fast in recent weeks:
- German July factory orders fell 11.7 percent.
- Composite final August euro area purchasing managers' orders fell further below the 50 growth/contract line to 46.7.
- Services sector PMI at 47.9 is into the recessionary zone.
- Manufacturing PMI also slumped, with the German measure below 40.
- Euro region July output producer prices plunged further, to minus 7.6 percent annually.
- The July ECB bank lending survey showed credit conditions and lending tightened significantly.
According to Bloomberg News Macro-Strategist Simon White, one of the best leading indicators of economic growth in the euro zone is M1 money supply. It has turned down sharply in recent months, pointing to continued weakening in the economy.
If the ECB does pause, as futures market pricing indicates, President Christine Lagarde will no doubt advocate a "higher for longer" policy stance at the following press conference. Keeping interest rates like a "Table Mountain,” as Bank of England Chief Economist Huw Pill described it in a speech on Aug. 31, is rapidly becoming the lodestar of major central banks. Even though rate cuts aren't priced into euro money-market futures until mid-2024, the ECB will be determined not to give the impression that the rate-hiking cycle could swiftly reverse.
Concern about a secondary upward lurch in inflation, driven by higher energy costs, is the main worry of ECB hawks who wish to continue increasing borrowing costs. Rising crude oil prices, exacerbated by production cuts, have contributed to an even wider range of opinions than usual in recent weeks:
- Hawks: Belgian Governor Pierre Wunsch, Latvian Governor Martins Kazaks, Austrian Governor Robert Holzmann and Slovakian Governor Peter Kazimir.
- Leaning hawkish: Dutch President Klaas Knot. Bundesbank President Joachim Nagel, Executive Board Member Isabel Schnabel.
- Studiously non-committal: President Lagarde, Bank of France Governor Francois Villeroy de Galhau, Chief Economist Philip Lane.
- Doves: Italian Governor Ignazio Visco, Portuguese Governor Mario Centeno.
A Bloomberg survey of economists shows opinion almost evenly split between a hike or a pause. It's evidently time for a classic ECB compromise. Skipping a move this week but maintaining the threat of a final hike until later in the year might help prevent rate-cut expectations from becoming embedded. A pause presents signaling problems — but the Federal Reserve was able to successfully navigate taking a break at its June meeting and resuming its tightening progress a month later.
Euro forward inflation expectations remain at their highest for a decade and, unhappily for the ECB, are still well above its 2 percent target. Schnabel last week warned of risks of re-inflation amid deteriorating growth, leading to stagflation. The minutes from the ECB’s July meeting showed participants expressing concern about some of the effects of monetary tightening.
So measures other than interest rates may come into play. The ECB is already reducing its balance sheet, but increasing the passive rundown of its €5 trillion ($5.3 trillion) portfolio would be logical. Currently, the proceeds of maturing bonds from the larger legacy Asset Purchase Program aren’t being reinvested, whereas redemptions from the more flexible Pandemic Emergency Purchase Program will continue to be wholly reinvested until the end of next year. This might be about to change.
Core euro nations have inverted yield curves, where shorter-term debt yields are higher than those on longer-dated bonds. This can have a depressive economic effect and is often seen as a harbinger of recession. Increasing quantitative tightening should have greater repercussions on bonds with longer maturities given the extended maturity profile of the ECB’s holdings. It might help reverse the inversion.
Germany’s Nagel has frequently called for more QT once rates hit a peak. Austria’s Holzmann said in late August that he’s “a big advocate of starting the debate on ending PEPP reinvestments sooner than currently envisaged.” However, Knot argued on Wednesday that while “the rationale for continuing the reinvestments is becoming weaker...reneging on earlier guidance has a cost. At this moment I don’t think we should incur this cost.”
This ECB meeting isn’t going to be easy — but the euro area economy could sure welcome a breather. It may even lead to better-informed monetary policy after a breathless year of continuous tightening. Time to follow the Fed’s playbook and mix things up a bit.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Views are personal and do not represent the stand of this publication.
Credit: Bloomberg
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