The “big first step” is coming: interest rates pivot

“An important first step”
Now comes the pivot in terms of interest rates

by Stefan Schaaf

In July, the ECB will raise interest rates again for the first time in eleven years. However, this does not mean the end of high inflation. “We have to improve,” says Lagarde’s head of the central bank.

Monetary policy doesn’t work overnight, especially when it comes to fighting inflation. Works more from tomorrow to the day after tomorrow, textbooks specify a delay of about one year. As a result, inflation in the euro area will not fall automatically from 21st July if the European Central Bank (ECB) subsequently raises its key interest rate by 25 basis points. So the central bank will need to do more to contain inflation, which recently hit 8.1%. in the monetary union.

ECB President Christine Lagarde made a promise on the matter on Thursday. “We will deliver,” she said, referring to the ECB’s inflation target of two percent. According to its own forecasts, however, the central bank will not achieve this goal again until 2024. In a year or two, it will be clear if Lagarde has kept her promise. “The first important step,” she said, “has been taken,” and she spoke of the trip.

This time, the Governing Council of the ECB traveled to Amsterdam for its annual meeting outside Frankfurt and was a guest of the Dutch central bank. A fundamental decision was made there: at the end of the month, the ECB will end the purchase of bonds from the APP program organized by Lagarde’s predecessor Mario Draghi. The PEPP pandemic purchasing program expired at the end of March. The ECB thus ends its net bond purchases, which have always been controversial due to their distorting effects on the financial system. In Germany, it was also discussed whether the purchases would undermine the ban on monetary financing of the state.

“Inflationary pressure has increased”

Discussions about unconventional monetary policy may actually end. With the announcement of a raise in key interest rates in July, the central bank is resuming its traditional monetary policy regarding interest rates. And in this respect, Lagarde surprised media representatives and the markets. “Inflationary pressures have widened,” she said as she expanded her recent blog postings.

At that time, she promised a rate hike by 25 basis points in July and September. But now it has put 50 basis points in the September window. “If the medium-term inflation outlook persists or deteriorates, a larger hike at the September meeting will be appropriate,” the press release said. Moreover, “Based on its current assessment, the Governing Council believes that a gradual but sustainable path for further interest rate increases is appropriate.”

But on this pathway, Lagarde backed off from the fact that it would be data dependent. She identified inflation expectations as the most important criterion and admitted to wrongly assessing her own forecasts: “We have to improve”. Like other central banks, the ECB was surprised by the rapid rise in prices. However, after the statements made during the press conference, the market is getting ready for the big step after the summer break. “If the medium-term inflation outlook remains unchanged or continues to rise, according to the ECB, key interest rates are likely to rise by more than 25 basis points in September,” says Jörg Kramer, chief economist at Commerzbank. “As we believe inflation risk is likely to increase further, we now expect a 50bp rate hike in September.”

Krämer expects the ECB to gradually raise the deposit rate to 1.5% by May. Currently, it is still minus 0.5 percent. and is an important benchmark for banks and savings banks when measuring bank deposit rates. There are therefore signs of a significant increase in savings interest rates in the coming months. The euro area’s actual principal rate of interest, the main refinancing rate, is now at zero percent and could then rise to two percent. Then, too, it would be time to see if Lagarde had kept her promise.

Lagarde shows the bazooka

However, the impending end of bond purchases also worries market players, especially in the case of heavily indebted Italy. Not surprisingly, market interest rates rose significantly following September’s Lagarde surprise. But the scope in the euro area was different. The profitability of the 10-year Bund reached the level of 1.43%, which would have compensated for inflation not so long ago. The daily increase was eight basis points, according to Bloomberg data. Meanwhile, the yield on Italian government bonds rose by 19 basis points to 3.35%. All this is not dramatic, but the possible fragmentation of financial markets worries the ECB. It can then no longer effectively enforce its monetary policy.

Lagarde appeared to be aware of this problem and at a press conference showed the market a bazooka worth 1.7 trillion euros. With that much money, the ECB has bought bonds from the market under the PEPP and wants to reinvest the repayments until further notice. Lagarde emphasized flexibility in reinvesting in jurisdictions and maturities. In other words: expiring German government bonds can be replaced by long-term Italian bonds. “The flexibility built into the PEPP reinvestment program seems to be, at least for the time being, the only way to mitigate the risk of fragmentation,” said Dave Chappell, Columbia Threadneedle Fixed Income Manager.

However, Lagarde apparently has other ideas about the PEPP treasury on the balance sheet. As a side note, it announced that it would consider reinvesting PEPP funds and “green” refinancing offers for banks (TLTROs) in the coming months. A “green TLRTO” could be the next big thing for the ECB after a rate hike. But even that would only have a very long-lasting effect.

This line first appeared in Capital.

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