OVERVIEW: With the headline HICP Y/Y rising to 9.9% from 9.1% in September, policymakers are likely to proceed with another outsized rate hike after a 75bp hike in September. In market price terms, a 75 basis point increase is valued at around 80% and a 50 basis point increase at 20%. Looking beyond inflationary developments, concerns about growth continue to escalate in the Eurozone, with the composite PMI falling to 47.1 in October from 48.1 in September. Nevertheless, with the ECB’s measure of 5-year and 5-year inflation expectations rising to around 2.3% from around 2.2% at the time of the previous meeting, policymakers will be forced to raise rates again this this month. As for other measures to consider, an October 13 source report suggested that the GC discussed the timing of the balance sheet reduction at the Cyprus meeting earlier this month. The report notes that language around reinvestments could be changed at the October meeting, before presenting plans to reduce the balance sheet in December or February, and then starting QT during the second quarter of 2023. Elsewhere, the next meeting could see policymakers change the terms of its TLTRO given that banks can currently store cash from operations at the ECB and earn a risk-free profit from recent rate hikes.
PRELIMINARY MEETING: In line with market prices and against a shared consensus among analysts, the ECB chose to pull the trigger on a 75 basis point hike, bringing the deposit rate to 0.75%. The release notes that the GC plans to further increase rates over “several” upcoming meetings, while adopting a data-driven, meeting-by-meeting approach. The ECB chose to continue with its current reinvestment policy while suspending its two-tier system by setting the multiplier to zero. The attached staff forecast saw inflation projections for 2022, 2023 and 2024 revised upwards, with the 2024 forecast of 2.3% indicating further policy tightening is needed. On the growth front, 2022 GDP has been revised up a bit, however, 2023 has been cut to 0.9% from 2.1% as the downside scenario touts the possibility of negative growth. Regarding the size of the hikes ahead, Lagarde noted that 75 basis point increases are not the norm, but the moves won’t necessarily get smaller as the ECB moves towards the terminal rate. . Despite indications that the GC will follow a meeting-by-meeting approach, Lagarde said hikes will likely take place in more than two meetings, but less than five, so markets will be looking to see if such a view has mentioned in the minutes of the meeting.
RECENT ECONOMIC DEVELOPMENTS: HICP Y/Y in September rose from 9.1% to 9.9% and the basic indicator rose from 5.5% to 6.0%, as the stock was boosted by the continued surge in prices energy and food and Germany’s dismantling of its discount transport ticket system. In terms of market inflation indicators, the ECB’s preferred measure of 5y5yr expectations rose to around 2.3% from around 2.2% at the time of the previous meeting. On the growth front, the flash estimate of Q3 GDP is only due on October 31st. That said, the composite PMI for October fell to 47.1 from 48.1 in September. As a result, S&P Global noted that “the eurozone economy is expected to contract in the fourth quarter given the deepening output loss and deterioration in demand seen in October, adding to speculation that a recession seems increasingly inevitable. The unemployment rate in August remained stable at 6.6%, however, worries over the job outlook have sparked discussions within the EU on the potential relaunch of the SURE scheme (aimed at mitigating unemployment risks in case of emergency).
RECENT COMMUNICATIONS: Since the previous meeting, President Lagarde (October 14) has said that inflation in the euro area is expected to remain above the ECB’s target for an extended period and that the Governing Council plans to raise inflation further rate in future meetings. German opinion leader Schnabel (September 30) said a robust approach to monetary policy is needed given the uncertainty about the persistence of inflation. Chief Economist Lane (September 29) said the central bank is still trying to achieve neutrality, but is not yet taking a position on whether that will be enough. He added that the exchange rate channel is not important enough to influence monetary policy. Frenchman Villeroy (October 11) noted that the ECB should reach the neutral rate of almost 2% by the end of the year, adding that the Bank could act more slowly after reaching a neutral rate. Elsewhere, Slovenian Vasle believes the ECB should hike 75 basis points in the next two meetings and then could start reducing the balance sheet in 2023.
RATES: The ECB is expected to raise its three main interest rates by 75 basis points each, taking the deposit rate to 1.5%, the main refinancing rate to 2% and the marginal lending to 2 .25%. According to a Reuters survey, 27/36 expect the deposit rate to be raised by 75 basis points to 1.5%, 7/36 expect 50 basis points and only 2/36 expect 25 basis points. In market price terms, a 75 basis point increase is valued at around 80% and a 50 basis point increase at 20%. The decision to continue interest rate hikes follows the headline HICP Y/Y in September which rose from 9.1% to 9.9% and the base measure from 5.5% to 6, 0%. Also, since the previous meeting, there hasn’t been much advice from policymakers suggesting that the Bank will increase or decrease the magnitude of rate hikes. As a reminder, at the September press conference, Lagarde said the hikes will likely take place at more than two meetings, but less than five. Beyond this week, markets are fully pricing in another 50 basis point move in December, with the deposit rate expected to peak just below 3% towards the third quarter of next year. In terms of guidance from policy makers, Slovenian Vasle believes that the ECB should increase by 75 basis points in the next two meetings, while Frenchman Villeroy remarked that the ECB should reach the neutral rate of almost 2%. by the end of the year. Note that recent reports suggest that an ECB staff model puts the terminal rate on target at 2.25%. That said, the report noted that policymakers were skeptical of the model’s accuracy.
QT: In terms of other steps to consider, an October 13 source report suggested that the GC discussed the timing of the balance sheet reduction at the Cyprus meeting earlier this month. The report notes that language regarding reinvestments could be changed at the October meeting, before outlining plans to reduce the balance sheet in December or February, and then start QT in the second quarter of 2023. ING takes a more cautious, suggesting that the markets “have it ahead of them”, noting that “although the discussion may have started at the ECB, with the current risks to financial stability, the recent UK experience and a very uncertain macroeconomic outlook, QT is still further.” In addition, Chairman Lagarde’s guidance stated that rates would need to be cut to neutral (estimated at around 2%, according to Villeroy) before QT could begin. In terms of a potential course of action, ING suggests that a start of QT would imply the end of reinvestments rather than the active sale of bonds, which under the APP could begin in the spring of 2023 at the earliest.As such, any discussion has Around QT at this point is likely to be vague. SGH Macro expects details not to be announced until February.
TLTRO: Elsewhere, the next meeting could see policymakers change the terms of its TLTROs given that banks can currently store cash from operations at the ECB and earn a risk-free profit from recent rate hikes. Sources reported via Reuters suggested a decision on what to do about it could be made as soon as the next meeting. In terms of available options, SGH Macro indicates that the ECB could:
- Reset the terms of the original TLTRO loans.
- Adjust the rates paid specifically on TLTRO-related deposits.
- Establish a general threshold of excess reserves beyond which the ECB and national central banks will not pay interest.
SGH Macro leans towards the third option by implementing a “reverse tiering” system according to the SNB. ING is also of the view that this would be the easiest system to implement as opposed to resetting the TLTRO conditions, as it would damage the credibility of the Bank “and lead to banks’ reluctance to use the TLTRO again. TLTRO in the future”. Alternatively, Rabobank suggests that “reverse tiering would harm the effectiveness of the interest rate instrument”. Instead, Rabo believes that “lowering banks’ excess reserve compensation equal to their use of the TLTRO is the most feasible solution”, although he has weak conviction on that call.