More Upbeat Inflation And GDP Developments Point To Earlier Monetary Policy Tightening

Last Thursday, the European Central Bank (ECB) opened the door to an earlier monetary policy normalization than it had foreseen last December. Inflation--already elevated because of energy prices--has clearly surprised on the upside in the past two months, while GDP recovered to pre-pandemic levels in Q4 2021, and the unemployment rate is back to its lowest on records (see chart 1). The ECB has acknowledged that the economic effects of the pandemic are continuing to diminish, so that the economy may reach full potential earlier than it previously expected. This may translate into higher prices more quickly than thought. With risks to price forecasts now on the upside, the ECB has given to understand that it is now unlikely to wait until 2024 to raise rates. We believe that this could lead the central bank to bring its rate normalization forward to the final quarter of 2022.

Chart 1

We expect soaring energy prices--currently the main driver of inflation--to be temporary in nature and recede toward the end of the year (see chart 2). However, the energy price spike has proven less transitory than previously expected and could continue to push up prices this year, especially if geopolitical tensions with Russia continue to weigh on European energy supplies: 26% of energy imported to the EU comes from Russia. Based on the current forward curve for oil prices, and if the euro stays at its current levels of $1.14 (assumptions that the ECB will use to update its forecasts in March), the contribution of energy prices to eurozone inflation could amount to 1.3 percentage points (pp) this year, compared to 1.2 pp in 2021 (see chart 3). This would be an uplift from the previous assumptions that fed into the ECB's inflation forecasts of December.

Chart 2

Chart 3

Although energy supply shocks don't tend to lead to a wage-inflation spiral in Europe, the longer they last, the more likely they are to be embedded in price expectations. This might ultimately help push up core inflation somewhat. In the medium term, though, we still expect wages to be driven primarily by employment trends and relatively sticky labor markets in Europe (see: "Where Is The Wage Inflation? Not In Europe," published Dec. 16, 2021, on RatingsDirect). The latest readings from Italy on contractual wages still point to very modest wage increases (at 0.7% year on year in December 2021) despite a fast recovery in jobs. In France, where employment is already above the pre-COVID-19 pandemic level, hourly wage growth came out at just 1.9% year on year in Q4 2021, little changed from 1.8% the previous quarter. Nonetheless, eurozone earnings' growth is likely to gain pace toward the end of the year as the labor market continues to tighten and may possibly outpace productivity in 2023. Add to this the ongoing price pressures for non-energy industrial goods arising from supply-chain bottlenecks, and eurozone underlying inflation is set to rise more durably toward 2% over the next three years.

The ECB's Three Criteria For Liftoff May Be Met This Year

Underlying inflation edging closer to 2% and inflation expectations rising. The survey of professional forecasters' two-year inflation expectations, currently at 1.8%, have visibly converged to five-year expectations, which themselves have reached 2% for the first time since 2013. Five-year expectations are now much more evenly distributed around 2% than they were three to six months ago (see chart 4). This signals that the ECB's three criteria for liftoff may soon be met:

• Near-term inflation should be on target at 2%;
• Medium-term inflation (over a three-year forecast horizon) should remain on target;
• Core inflation should head durably toward 2%, well ahead of the end of the five-year projection horizon.

We therefore think the ECB will likely start to prepare markets for liftoff from its next meeting. Key variables to watch until then will thus be inflation (for which Brent oil and euro-dollar exchange rate development will continue to be key), wages, and the scope for ECB's growth forecasts revisions.

Chart 4

If the ECB estimates that all three conditions are met by March, it will pursue a sequence of policy normalization for a gradual liftoff. First, the ECB will phase out net asset purchases. For now, the Pandemic Emergency Purchase Programme (PEPP) is set to stop in March, and the Asset Purchase Programme (APP) is set to be increased to €40 billion net purchases at the start of Q2, and then to be reduced by €10 billion each quarter. Given this sequency, it seems difficult for the ECB to end APP net purchases before the start of Q4, which could pave the way for a first rate hike at the end of Q4. In December, the ECB will also receive the first ECB staff projections for 2025, which could help to assess whether medium-term inflation prospects remain on target.

What Would The ECB Rate Liftoff Look Like?

According to its forward guidance, once it has phased out net asset purchases, the ECB would soon start its interest rate rises. We expect the central bank to start by raising its deposit rate to -0.25% from its current level of -0.5%. This would restore the 25-basis-point (bp) ranges between its three policy rates (the deposit rate, the refinancing rate, and marginal lending facility). After that, the ECB can lift the three rates by 25-bp steps in tandem, in a quarterly cadence, if data on wages and growth remain on track.

Nonetheless, we note that the current level of excess reserves—and thus excess liquidity--held by banks remains unprecedently high and is unlikely to decrease significantly until the ECB reduces the size of its balance sheet. It would also need to stop the full allotment procedure to restore the funding role of the interbank market, which it might want to do at a later stage of the monetary policy normalization cycle. This means that short-term rates will likely continue to track the ECB's deposit rate and not the refinancing rate. Thus, as the deposit rate currently stands at -0.5%, it will take two hikes to get the main policy rate back to 0%.

We would expect the ECB to stop raising rates when it considers them to have reached the equilibrium rate for the economy. There is no reason for monetary policy to turn restrictive at this stage. This likely lies around 1.5%, i.e., the ECB's 2% inflation target plus the neutral rate, which is still in negative territory, according to recent estimates (see the speech by ECB board member Isabel Schnabel "A New Strategy In A Changing World" Nov. 24, 2021). In other words, it will only take only eight hikes for the ECB deposit rate to reach this level of interest rate (six steps for the refi rate if excess liquidity has diminished until then and it is seen as the main policy rate again). This could be carried out as soon as mid-2023 if the data remain on track, or later if inflation recedes sharply or if activity data and wage growth disappoint in H1 2022.

Meanwhile, to be consistent with its interest rate policy, the terms of Targeted Longer-Term Refinancing Operations (TLTROs) could be tightened or even phased out before the ECB starts raising interest rates. This is because TLTROs offer an even lower interest rate for banks on their borrowings than the deposit rate, and they are also more active tools to push banks to expand credit. The ECB has already decided to end the special rate period on TLTROs (a discount of -50bps on the deposit rate) in June. A decision on whether to continue them might be postponed to the ECB June meeting. Added to this, the tiering system for banks is also likely to be phased out from the time of the second rate hike. This is because banks would no longer be paying a negative rate on their deposits, so there would be no need to dampen the negative side-effects of negative rates on banks' profits.

What About Balance-Sheet Normalization?

While the path of normalization for rates is relatively clear, there is still a lot of uncertainty surrounding the ECB's plans to downsize its balance sheet, given that it hasn't gone through this process in the past. So far, the ECB has rather erred on the side of a passive normalization, i.e., to let assets roll off from its balance sheet as they mature rather than by actively selling. This would ensure that interest rates on sovereign bonds do not rise too abruptly. We estimate that the stock of bonds held by the central bank puts more downward pressure on yields than the flow of net purchases.

With PEPP reinvestments to end in 2024 and the average maturity of the ECB's portfolio holdings at around a bit more than seven years (see chart 5), this would mean that passive balance-sheet normalization could continue until 2031. It could take even longer if the ECB decides to continue reinvesting the APP longer than the PEPP. Current forward guidance suggests that reinvestments will be made for an extended period of time past the date when the ECB starts raising its interest rates, which could be a bit longer than 2024.

Another component of balance-sheet normalization will be the central bank's need for reserves. These have increased since the ECB started expanding its balance sheet, in part linked to regulatory requirements. Thus, we expect the ECB's balance sheet to be relatively bigger than it was before it started quantitative easing. Following the U.S. experience pre-pandemic, it might take the ECB some trial and error to understand how big its balance sheet should be (see chart 6).

Chart 5

Chart 6

Related Research

• Where Is The Wage Inflation? Not In Europe, Dec. 16, 2021