ECB speeds up stimulus exit and opens path to interest rate rise

The European Central Bank has scaled back its bond-buying stimulus plan in response to inflation being driven up by the war in Ukraine, while giving itself more flexibility on the timing of a potential interest rate rise this year.

“The Russian invasion of Ukraine is a watershed for Europe,” the ECB said in a statement after its governing council’s meeting in Frankfurt on Thursday, adding that it would “take whatever action is needed . . . to pursue price stability and to safeguard financial stability”.

Analysts interpreted the move to speed up the ECB’s exit from buying more bonds as a signal that it could raise interest rates in the fourth quarter in an effort to contain soaring inflation – which would be the first such move for more than a decade.

However, the ECB also gave itself more leeway to wait longer before raising interest rates after its bond-buying ends. “It is a bit of a mixed message, even though the market has interpreted it as hawkish overall,” said Dirk Schumacher, head of European macro research at Natixis.

Investors responded by selling euro-zone bonds, pushing Germany’s 10-year yield to 0.27 per cent, the highest in more than three weeks. Riskier euro-zone debt was also hit, with Italian 10-year yields climbing 0.2 percentage points to 1.89 per cent. Bond prices fall when yields rise.

“A faster winding down of the asset purchase programme will perhaps come as a surprise to market participants who expected an ECB capitulation in the face of weaker growth forecasts,” said Seema Shah, chief strategist at Principal Global Investors.

The euro briefly rose after the ECB announcement, before falling 0.6 per cent to $1.1013 against the US dollar.

Christine Lagarde, ECB president, said Russia’s invasion of Ukraine had created “a major shock” for the euro-zone economy, adding that the central bank was forecasting higher inflation and lower growth over the next three years.

Setting out a quicker reduction in its bond-buying plans this year, the ECB said it would reduce asset purchases to €40 billion in April, €30 billion in May and €20 billion in June. Its earlier plan was to steadily reduce net purchases from €40 billion a month in April to €20 billion a month from October.

It could stop adding to its existing €4.6 trillion bond portfolio in the third quarter “if the incoming data support the expectation that the medium-term inflation outlook will not weaken even after the end of our net asset purchases”.

The separate €1.85 trillion emergency bond-buying scheme launched in response to the coronavirus pandemic would stop net purchases as planned at the end of March, it said.

However, the central bank dropped a commitment to end asset purchases “shortly before” it raises interest rates, saying instead that any change to rates would be “gradual” and come “some time” after asset purchases end, which Ms Lagarde said could mean months, or a week later.

Stagflation

The war in Ukraine has prompted some economists to warn about the risk of stagflation, in which a supply-side inflationary shock is combined with stagnant growth. This leaves the ECB in a difficult position, torn between the desire to tackle inflation that is expected to stay well above its 2 per cent target until at least next year and wanting to support the economy.

The ECB cut its growth forecast for this year to 3.7 per cent, down from 4.2 per cent, and Ms Lagarde said high inflation could put more downward pressure on demand. It raised its forecast for inflation this year from 3.2 per cent to 5.1 per cent. But crucially it predicted inflation would fade to 2.1 per cent next year and 1.9 per cent in 2024 – meaning it still has not fulfilled a key condition to raise interest rates.

“Inflation could be considerably higher in the near term,” Ms Lagarde said. “However, in all scenarios, inflation is expected to stabilise around our target by 2024.”

Only last month, the ECB governing council agreed it could speed up a “gradual normalisation” of its ultra-loose monetary policy. But the invasion of Ukraine and the sanctions imposed on Russia threw this plan into doubt after economists slashed their growth forecasts and predicted inflation would surge from the record level of 5.8 per cent reached in February.

Ms Lagarde said the ECB was working with the European Commission to “provide tools and the means to provide support” for Ukraine and its population, including the more than 2.1 million who have fled the country. European Union politicians have called on the ECB to open a swap line with the central bank of Ukraine and those of other countries receiving refugees to help them access euros, but its rules make this difficult.

The Eurosystem repo facility that allows the ECB to provide euro liquidity to central banks outside the single currency zone has also been extended until January 15th, 2023. – Copyright The Financial Times Limited 2022

Article Source – ECB speeds up stimulus exit and opens path to interest rate rise – Irish Times – Tony Stubbington, Martin Arnold

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