By Konstantin Veit, European Rates Portfolio Manager en PIMCO
Although the European Central Bank (ECB) will continue to raise interest rates this year, the end point remains uncertain. The ECB has made it clear that it expects to raise interest rates significantly to a restrictive level, in order to ensure the timely return of inflation to its medium-term target of 2% (Eurozone inflation has been around 10%).
A market discounted ceiling rate of around 3.25% does not seem unreasonable given the large uncertainty that remains about inflation dynamics, and relative to other major developed market jurisdictions such as the UK or the US. Our conviction remains low as to the pace and extent of ECB rate hikes, given the unknowns around inflation developments. In this respect, we do not disagree with the terminal rate currently discounted by the market, especially after the somewhat hawkish stance adopted at the December meeting. A further rate hike of 50 basis points at the next meeting in February seems a given, although visibility beyond the short term remains low.
Eurozone economic data have held up reasonably well so far. The European Central Bank has a primary mandate, which is price stability, so it is expected to do whatever is necessary to bring inflation back to target within a reasonable time frame. If the ECB ends up raising rates in line with market expectations, it is unlikely to cause a significant deterioration in growth from the current base. If inflation dynamics force the ECB to tighten financial conditions by significantly more than current market rates, risks to growth would certainly increase. In such a situation, fiscal authorities would probably intervene to support growth, ideally in a way that does not add fuel to the inflationary fire.
The principles of balance sheet reduction implicitly recognise the institutional set-up of the euro area, suggesting limited scope for the ECB to consider trade-offs between quantitative tightening and policy rates. Any exercise to reduce bond holdings will essentially take the form of a back-end programme. The ECB wishes to avoid a situation like that of the Bank of England, which sought to reduce its bond holdings for monetary policy purposes, but instead purchased bonds for financial stability reasons. The ECB communicated that, while its Governing Council continues to regard policy rates as the main instrument of monetary policy, it is desirable that the balance sheet be normalised in a measured and predictable manner over time.
The central bank also clarified that the tools to safeguard the orderly transmission of monetary policy will be maintained, in particular the flexible reinvestments under the emergency purchase programme and the new transmission protection instrument. While the ECB did not rule out the sale of bond holdings, the principles focus on a gradual, orderly and passive reduction of its regular reinvestments under the asset purchase programme (APP), a strategy supported by the relatively favourable maturity structure of its bond portfolio.