By Konstantin Veit, Portfolio Manager at PIMCO
Summary:
- Headline inflation surprised meaningfully to the upside again in March, which makes a further upward revision of the ECB’s inflation projections in June all but certain.
- With the ECB more concerned with the inflation outlook than growth, we believe it will continue the process of policy normalisation, with targeted fiscal policies in charge of supporting private demand unless the economic situation deteriorates markedly.
- We do not believe the ECB will take significant monetary policy decisions at the April meeting, but its macroeconomic staff projections in June will likely provide the ECB cover to end net asset purchases in July, with a first 25bps interest rate hike in September a plausible scenario.
- While the ECB will aim for a non-disruptive normalisation of monetary policy, risks to the macroeconomic outlook and central bank communication challenges remain elevated.
Additional thoughts:
Asset Purchases and Interest Rates:
- The ECB concluded net asset purchases under the pandemic emergency purchase programme (PEPP) in March, and communicated that net asset purchases under the regular asset purchase program (APP) will continue in Q2 with €40bn per month in April, €30bn in May and €20bn in June. Purchases in Q3 will be data-dependent, but we believe the ECB will end net asset purchases in July, particularly if inflation continues to surprise to the upside.
- On policy rates, at the March meeting the ECB dropped the lower bias on its forward guidance on interest rates and pointed out that any adjustment of policy rates will take place “some time after” the end of net asset purchases, with the precise timing of lift-off again data-dependent. President Lagarde highlighted that “some time after can be the week after, but it can be months later”. Comments from Governing Council members suggest that the first policy rate hike could happen towards the end of the year, and we believe September is plausible for a possible rate increase.
The market prices two full 25bps rate hikes by the end of this year, which seems like a reasonable scenario to us. We think the ECB will increase the deposit facility rate as well as the main refinancing rate by the same amount, keeping that policy rate corridor unchanged. A tightening of the corridor would reduce the incentive scheme embedded in the current long term refinancing operations and discourage money market activity more broadly. Nevertheless, in a context of abundant excess reserves, the deposit facility rate remains the sole reference rate for money markets, a situation likely to continue for years to come given the sheer amount of excess liquidity in the system and lack of any active balance sheet run-off plans.
Over the near to medium term, we believe the ECB will certainly aim for ending net asset purchases and getting back to a zero policy rate, with little ambition beyond that. Over the medium to longer term, there remains considerably uncertainty where a neutral policy rate for the Euro area might be, but anything meaningfully above 1% seems somewhat less plausible in comparison to other developed market jurisdictions, such as the UK or US. Current market pricing of a 180bps interest rate cycle, therefore, could suggest marginally restrictive policy territory for the ECB.
TLTROs and Tiering:
- The final targeted longer-term refinancing operations (TLTRO) allotment took place in December, and the ECB has so far provided limited indications regarding its future TLTRO plans. While we expect the ECB to continue longer-term refinancing operations, the ECB will aim to return to a pre-COVID pricing model, allowing the cost to follow the policy rates evolution by setting it equal to the average policy rate over the life of the operation. Along those lines, the ECB announced that it expects the special pandemic conditions applicable under TLTRO III to end in June this year, a decision we believe will be officially taken at the April meeting.
