ECB sets stage for another big hike with jumbo move possible

Bloomberg

The European Central Bank (ECB) is prepared to at least repeat the half-point increase in interest rates it delivered last month, with an even bigger move not to be excluded as inflation nears yet another record.
That’s the message from ECB officials who joined the Federal Reserve’s annual Jackson Hole symposium, which wrapped up Saturday. Fed Chair Jerome Powell set the tone, saying US borrowing costs are headed higher and will stay there “for some time.”
The 11, mostly hawkish, ECB Governing Council members who travelled to Wyoming struck a similar note less than two weeks before September’s policy meeting. Executive Board member Isabel Schnabel, the most-senior ECB official in attendance, urged her colleagues “to signal their strong determination to bring inflation back to target quickly.”
Euro-zone consumer-price data due Wednesday are likely to hammer home the urgency. Estimates point to another all-time high of 9% — more than four times the 2% target — with a weakening euro exacerbating the problem by making imports costlier.
Policy makers are battling to stabilize prices after seeing inflation run out of control this year. But their ability to slam on the brakes is constrained by the growing risk of a recession in Europe and the fact that they have no control over the war in Ukraine and the Russia’s willingness to use energy supplies to disrupt the continent’s economy.
More dovish ECB officials such as Chief Economist Philip Lane and Greece’s Yannis Stournaras will get a chance to make their case this week. Some in that camp reckon a downturn in the 19-nation currency bloc may cool prices.
As well as rates, other topics broached at Jackson Hole included the euro’s slump against the dollar and how to reduce the trillions of dollars of bonds the ECB bought during recent crises to help the economy. Here’s a rundown of everything we learned:
After a larger-than-expected half-point increase at liftoff in July, a sizable minority on the 25-member Governing Council is willing to consider a 75 basis-point step on Sept. 8, with Austria’s Robert Holzmann, the Netherlands’ Klaas Knot and Latvia’s Martins Kazaks all setting 50 basis points as the minimum.
None of those officials indicated they’ll push strongly for a bigger move, citing the importance of data and forecasts that are still to arrive. But fresh ECB staff projections due next month will probably show significant upward revisions that may put 2023 inflation at more than 5%, according to people familiar with the situation.
The euro has lost more than 12% against the dollar since January and has become stuck below parity — worsening the inflation outlook as energy is priced primarily in the US currency. On trade-weighted terms, the euro has depreciated about 4% this year.
While ECB officials maintain that the exchange rate isn’t a policy target and represents only one factor when assessing the economy, some are sounding the alarm. Rehn called the situation a “significant consideration in setting monetary policy.”
Even some of the ECB’s more cautious policy makers, like Finland’s Olli Rehn and France’s Francois Villeroy de Galhau, stress the need for “significant” action — language that’s thought to signal support for another 50 basis-point step.
Schnabel, meanwhile, said that even if a recession hits, “we have basically little choice than to continue our normalization path.” Bundesbank chief Joachim Nagel said it’s “much too early to think about” when rate increases should stop.
Hawks may end up using the prospect of a 75 basis-point hike as a bargaining chip in other debates. But it shouldn’t be forgotten that the idea of a half-point increase in July was considered extremely unlikely until just days before that decision.
There’s growing concern that people may soon start to lose confidence in the ECB’s ability to control consumer prices.
Rehn highlighted the risk that inflation expectations become unanchored, while Kazaks said second-round effects are becoming “more transparent and obvious.” Schnabel warned that the likelihood and the cost of that scenario is “uncomfortably high.”
The main driver of the price pressure — the war in Ukraine and its effect on energy costs — isn’t going away.
Europe faces a “protracted confrontation” with Russia, so reduced natural gas supplies and higher fossil-fuel prices will be a “longstanding phenomenon,” according to Rehn.
Years of asset purchases and generous long-term loan terms have left the euro-zone financial system with more than 4 trillion euros ($4 trillion) of excess liquidity.
Once the deposit rate rises from 0% next month, banks parking that liquidity at the ECB will start earning sizable risk-free income that risks distorting the effectiveness of monetary transmission while handing losses to the region’s central banks.
Many officials want the issue addressed sooner rather than later. Discussions have started, according to Rehn, who sees a possible solution at an upcoming ECB meeting.
Options include a reverse of the tiering policy used to partially shield lenders from the effects of negative rates, changes to how mandatory reserve requirements are handled and an update to the rules governing long-term loans, according to people familiar with the situation.
With rate hikes under way, shrinking the ECB’s balance sheet is the logical next step to consider. The Fed and the Bank of England have both begun reducing their bond holdings, and a debate about how to go about the issue in the euro zone is slowly starting.
Some more-hawkish ECB officials are ready to put the issue on the table — if not in September then certainly by year-end.
“The sooner we discuss it, the better it is, but that doesn’t mean — and this is what I think the market should understand — it doesn’t mean if you discuss it today, we employ tomorrow,” Kazaks said. “The first thing we need to do is get some policy space with interest rates.”