07/06/2023 As the ECB meets this week, it looks as though the central bank
has fully embraced its role to preserve financial stability beyond merely keeping inflation
at or around 2%. European Central Bank (ECB) chief Christine Lagarde said the central bank
will “take whatever steps are needed” to return inflation to 2% over the medium term. For
many, the choice of words were important. It sounded like she wanted to channel the spirit
of her predecessor, Mario Draghi, who famously said the central bank would do “whatever it
takes” to save the euro. Back in 2012, amid the sovereign debt crisis, the very future of
the euro was at stake. Draghi, with those few choice words, restored calm; and they have
become synonymous with ECB monetary policy since. The danger facing the Eurozone is very
different today but no less critical to the economy and perhaps to the future of the
Eurozone. Inflation is soaring and whilst a global phenomenon, the euro area is facing a
particularly acute problem. It’s also still wrestling with the legacy of its formation in
the threat posed by aligning all member states’ debt markets.
Stage is set
In a
blog
outlining her current thinking, Ms
Lagarde struck a noticeably hawkish tone in committing to ending QE rapidly, and cemented
the view among market participants that the ECB will hike rates in July. “I expect net
purchases under the APP to end very early in the third quarter. This would allow us a rate
lift-off at our meeting in July, in line with our forward guidance. Based on the current
outlook, we are likely to be in a position to exit negative interest rates by the end of the
third quarter.” And Ms Lagarde indicated a willingness to swing the axe on inflation. “If
we were to see higher inflation threatening to de-anchor inflation expectations, or signs of
a more permanent loss of economic potential that limits resource availability, the optimal
policy would become the same as for a demand shock: we would need to withdraw accommodation
promptly to stamp out the risk of a self-fulfilling spiral.” Aren’t we there already?
Lagarde had already noted that “the disinflationary dynamics of the past decade are unlikely
to return”. Eurozone inflation has risen to a record 8.1%, well beyond the ECB’s 2% target
and whilst staff projections envisage HICP inflation returning to 2% next year, market-based
measures do not suggest such a swift return to normal. The 5yr5yr inflation swap has moved
up to 2.4%. Moreover, ECB staff projections have been consistently wrong; there is no reason
to think that their 2023 and 2024 forecasts are accurate. Central banks insisted inflation
was transitory and are now forced to accept they were wrong. A
recent
paper from the ECB
amounted to a stark admission of failure. “Recent
projections by Eurosystem and ECB staff have substantially underestimated the surge in
inflation, largely due to exceptional developments such as unprecedented energy price
dynamics and supply bottlenecks,” the authors wrote. In cementing the market’s view for a
hike in July, Ms Lagarde appeared to send the euro higher, although money markets were
already pricing in a 50% chance that the ECB would raise rates by 50bps in July. This
likelihood has diminished somewhat, and the consensus is for the ECB to raise rates by 25bps
in July, though a larger move is not out of the question. The RBA surprised the market with
a 50bps hike on Tuesday – the ECB could yet do the same. Moreover, her comments in the blog
had largely been signalled earlier in May. Speaking in Slovenia two weeks prior, she said
asset purchases would wrap up early in the third quarter and that “the first rate hike …
will take place sometime after the end of net asset purchases…(and) this could mean a
period of only a few weeks”. This would imply July is a go. Recent commentary from various
ECB policymakers had already been beating the hawkish drum. Joachim Nagel, president of the
Germany’s Bundesbank, said the market should expect the first rate hikes soon. Francois
Villeroy de Galhau, head of the Bank of France, said he expects a ‘decisive’ June meeting
and ‘active’ summer. So, lots of jawboning and nothing particularly new but if you needed
any further persuading that the ECB is about to hike, Ms Lagarde has delivered. Villeroy de
Galhau commented: “Frankly, if you look at President’s Lagarde’s statement … the deal is
probably done because there is a growing consensus [and] I would play down the idea of a
short-term trade-off between inflation and growth. In the short run, our priority is clearly
… fighting inflation”. But a word of caution: Ms Lagarde said: “Markets shouldn’t
translate words into any percentage point moves.”
Fragmentation
Meanwhile, the ECB is fighting a war on
another front: fragmentation risk. As it seeks to tighten monetary policy, it risks sending
sovereign bond spreads wider. Ms Lagarde famously said at the start of her tenure that “we
are not here to close spreads”, but the messaging is now subtler and reflective of the
risks. Bond spreads are widening this year on the expectation that as the ECB ends asset
purchases, some countries’ debt will be perceived as riskier than others. The spread between
Italian 10yr bond yields and their German counterpart has risen to more than two percent,
from around one percent at the start of the year. This poses problems for the ECB that are
unique to it – in the absence of the financial repression of QE, national debt markets move
at different speeds as some are perceived riskier than others. So, this week it’s expected
that the ECB will commit to using additional new tools to ensure monetary policy is
effectively transmitted to all members. In other words, it will prop up debt markets in more
vulnerable economies to stop a blow-out in spreads. The language will be subtle enough but
strongly signal that it will seek to contain bond spreads even as it tightens policy.
Assuming it’s backed by most of the Governing Council, such a statement would show the ECB
has fully adopted Draghi’s commitment to do ‘whatever it takes’ to preserve the single
currency.