Seeking Compromise on a Rate Hike, But Can Progress on QT Help the ECB Get There?

13 December 2022

By David Barwick – FRANKFURT (Econostream) – Econostream continues to expect the outcome of this week’s European Central Bank Governing Council meeting to be a 50bp rate hike, a view we’ve held more or less since 28 October, when President Christine Lagarde clearly set the stage for a deceleration of the tightening pace.

Uncertainty about the precise timing of a deceleration led us to write on 9 November, when we suggested that December would bring a ‘modest reduction’ in hike size, that it was difficult to exclude anything. This has become more true since, and even if our central scenario endures, we see the probability of a renewed 75bp move as being only somewhat lower than that of 50bp, with the bigger option having gained ground.

The fact that we still expect 50bp on balance is owed in part to comments by hawks, many of whom have been less categorical than usual. We don’t doubt that most would still embrace another outsized rate move, but think they are hoping for progress in terms of balance sheet reduction, and that such progress, paired with hawkish communication, should allow a compromise around a smaller rate hike.

To be sure, it is possible that the ECB will make little headway with respect to quantitative tightening, and we would see the absence of progress here as a potential pathway to 75bp. In other words, if no satisfactory compromise involving QT is available, then the hawks would have less motive to make a concession in terms of interest rates – which, we note, have been widely declared the preferred policy instrument.

On the other hand, we fail to see how the hawks could be indulging in any wild QT phantasies anyway, implying little reason to think that the bar QT progress has to reach to help form a compromise is high. Council members across the spectrum seem well aligned – as we observed on 21 November - on the need for reduction of the balance sheet to proceed in a cautious manner (see here for a compendium of their remarks on the subject).

The data are another pathway to a 75bp rate hike. Whilst various aspects lend themselves to opposing views, factors such as scepticism – voiced also by Lagarde – about the peak of inflation having been reached, concerns about the solidity of expectations and worries of second-round effects are a potent mixture that, buttressed by any new negative information, could become an insuperable obstacle to a December deceleration.

In particular, we are thinking of the updated staff forecasts, which include a first projection for 2025.

We suppose that the question mark hovering over the inflation and growth outlook goes a long way toward explaining the ECB’s own evident uncertainty about what the outcome of their meeting will be; certainly it is a large part of the reason for our own unwillingness to ignore the 75bp scenario.

Still, it’s hard not to notice that opposition to another big step has mounted. We attach a lot of weight in this respect to the comments of Executive Board member Philip Lane. He will doubtless be quick to execute his own pivot if the ECB hikes this week by 75bp, but it is clear that such a decision would be at odds with what he said on 21 November and, in weaker form, one week ago today.

True, Lane has spent much of his term of office as chief economist on the wrong side of history, in particular repeating as late as January 11 his earlier assertion that the conditions for a rate hike were ‘quite unlikely’ to be fulfilled in 2022. But this only leads us to believe that he must have thought especially carefully before making (and then approving for publication) comments clearly downplaying a 75bp hike this month.

We also note Banque de France Governor François Villeroy de Galhau’s expression of support for 50bp. As with Lane, this was likely planned; the context was a random-seeming interview – his last of several before the quiet period - in which this was the answer to what was in effect the sole question. Villeroy prefers positions that carry the day, and he must have been expecting a 50bp hike when he came out in favour of it.

We too expect a 50bp hike on Thursday, but keeping in mind a relatively hawkish Lagarde performance on 28 November at European Parliament and on 18 November at the European Banking Congress, we attach a greater likelihood to 75bp than financial markets do. Besides potentially compensating for under-delivery on the QT front, such a hawkish surprise would address the concerns we mentioned above whilst laying to rest any doubts about the ECB’s resolve.

On other key aspects of the policy meeting and subsequent press conference, our thinking is as follows:

• On communication, if our baseline of a 50bp hike materialises, then Lagarde will be hawkish and highlight the ECB’s readiness to step up its game again if needed. Conversely, a 75bp surprise would be accompanied by dovish rhetoric, perhaps including a clear indication of deceleration from February.

• On quantitative tightening, it seems inevitable that interest rates will retain primacy, that balance sheet normalisation will be measured and predictable (Lagarde, Executive Board member Isabel Schnabel, Lane and Central Bank of Ireland Governor Gabriel Makhlouf have all said exactly this, while numerous other Council members have effectively said the same), that not fully reinvesting maturing securities in the APP portfolio will be the focus for now, and that flexible PEPP reinvestments and the TPI will ensure policy transmission. We assume QT will run in the background, Lane having called this ‘a universal consensus’. Will the ECB actually start QT? Rather unlikely; at most, we can imagine Lagarde indicating a starting date still a few months off - Council members seem mostly not to expect a clear timeline to emerge in December, and Lane has specifically suggested a ‘two-step process’ in which principles are defined first and a calendar finalised second, presumably in February.

• Lagarde remains unlikely to specify the neutral or the terminal rate, other than to say we’re close to the first and closer to the second.

• On the corridor between the key interest rates, which again at least one analyst thinks could be on the Council’s agenda this month, we think this is simply not yet seen as particularly relevant.