The European Central Bank (ECB) raised its deposit facility rate by another 50 basis points (bp) to 2% at the December meeting, bringing its policy rate to the upper end of most estimates for a neutral configuration for the Euro area, namely 1.25% to 2%.
The ECB made clear it expects to raise interest rates significantly into restrictive territory, aiming to ensure the timely return of inflation to its medium-term target of 2% – Euro area inflation has been running at about 10%. Indeed, the new Eurosystem staff macroeconomic projections foresee inflation above the ECB’s definition of price stability for the entire three-year projection horizon. A peak policy rate of around 3.25% priced in by the market doesn’t look unreasonable given the still large uncertainty over inflation dynamics, and relative to other major developed market jurisdictions such as the U.K. or U.S.
The balance sheet reduction principles implicitly acknowledge the institutional Euro area setup, suggesting limited scope for the ECB to entertain trade-offs between quantitative tightening and policy rates. Any bond holding reduction exercise will essentially take the shape of a background programme. The ECB is keen to avoid a situation such as when the Bank of England intended to reduce bond holdings for monetary policy purposes but acquired bonds on financial stability grounds instead.
The main implication of ECB balance sheet normalization will be considerably higher bond issuance to the market, and we expect net European government bond supply to more than double next year. Together with measures taken to better control money market rates and preserve the monetary policy transmission mechanism, this should continue to result in an easing of collateral scarcity, and help restore a more balanced relationship between European interest rate swaps and core government bond market pricing.
When will the ECB stop raising rates?
ECB President Christine Lagarde during the press conference emphasized that there is no forward guidance on interest rates, and the ECB remains firmly in meeting-by-meeting mode with inflation dynamics driving the future policy rate path. However, she also made clear that the pre-meeting market pricing of a 3% terminal rate is not judged sufficiently restrictive – and opened the door for additional 50-bp rate hikes at upcoming monetary policy meetings.