The ECB faces higher interest-rates and losses on its bond holdings

by Shaun Richards

This morning in Frankfurt ECB President Christine Lagarde has been setting out ger stall on monetary policy. In essence she is presenting herself as a doughty and valiant inflation fighter.

For the ECB, displaying our commitment to our mandate is vital to ensure that inflation expectations remain anchored while inflation is high. We are committed to bringing inflation back down to our medium-term target, and we will take the necessary measures to do so.

How is that going? Well the Deposit Rate of 1.5% rather pales when we note this.

The euro area annual inflation rate was 10.6% in October 2022, up from 9.9% in September. A year earlier, the
rate was 4.1%. ( Eurostat)

Even she will struggle to find an economic theory that suggests an interest-rate some 9.1% below the inflation rate will be a success. Also there is something else in the detail which raises an issue we no longer get told about which is convergence with the Euro area. Anybody can see how that is going too.

The lowest annual rates were registered in France (7.1%), Spain (7.3%) and Malta (7.4%). The highest annual
rates were recorded in Estonia (22.5%), Lithuania (22.1%) .

What will she do?

Although she does not put it like that this is quite a confession of failure.

Inflation in the euro area is far too high, having reached double digits in October for the first time since the start of the monetary union.

Then she sets out her case.

That is why we have been raising rates at our fastest pace ever – by 200 basis points in our last three policy meetings. These rate increases help us to withdraw support for demand more quickly. And they send a clear signal to the public of our determination to bring down inflation, which will help anchor expectations.

She is determined to give the impression of action and “200 basis points” sounds so much better than 2% which some may start comparing with an inflation rate above 10% as inflation is never expressed as 1060 basis points.

Then we get her main message.

We expect to raise rates further – and withdrawing accommodation may not be enough. Ultimately, we will raise rates to levels that bring inflation back down to our medium-term target in a timely manner.

That is being taken as aggressive although a little care is needed because the estimate of the neutral rate for the Euro area is similar to the inflation target at 2%. So we will presumably be there next month. Technically as some say below 2% we will be there next month on current expectations.

Trouble Trouble Trouble

We find ourselves in Taylor Swift territory because President Lagarde is keen to emphasis this.

As I explained recently, how far we need to go, and how fast, will be determined by the inflation outlook.

And again.

In this setting, displaying commitment to our mandate is vital to ensure that inflation expectations remain anchored and second-round effects do not take hold.

Perhaps she should talk to this woman.

Despite eurozone inflation hitting a record high of 4.9 per cent in November, well above the ECB’s target of 2 per cent, Christine Lagarde said it was likely to have peaked and would decline next year.
“I see an inflation profile that looks like a hump . . . and a hump eventually declines,” she said at a Reuters virtual event. Lagarde also repeated her assertion that the ECB was “very unlikely” to raise interest rates next year. ( Financial Times 11 months ago)

It is hard to believe now that 4.9% was a record as we have more than double that. But the fundamental issue is that someone who has been about as wrong as you can be on inflation wants us to look forwards based on her expectations. What could go wrong?

This is a real issue of our times because policy is frequently based on forecasts from bodies which are awful forecasters. In my home country the media were plugging numbers from the Office for Budget Responsibility ignoring the fact that it is always wrong. Here we see that the ECB President is in effect going to be setting the wrong interest-rates because her expectations are much more likely to be misleading than useful.

Why do they do it. Well they can manipulate expectations much more than the actual numbers. Whilst their impact on the actual numbers is for example omitting owner occupied housing that is much less than their crimes with assumptions and forecasting.

TLTRO Day

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This is something else which is awkward. During the pandemic central banks basically threw cheap money at the banks. In the Euro area the cries of “The Precious! The Precious!” were so loud they were paid via negative interest-rates to take the money. That is now awkward because they could round-trip it and get 1.5% now and presumably 2% next month. We do not often see a real world example of the economics concept of “free money” but this is one.

Even the ECB realises that hard pressed workers and consumers will be unhappy about this so they changed the rules.

That is why we recently decided to amend the terms and conditions of our targeted longer-term refinancing operations (TLTRO-III).

Well today is the day or rather the first tranche of repayments.

It brings with it 2 problems. The first is back to expectations and forecasts as the ECB hot this wrong by making it too easy for the banks. Also I recall Mario Draghi assuring us it was a “rules-based organisation” as it has just broken them.

Quantitative Tightening

This is another area that could go off like a hand grenade. We start with a familiar issue which is that this time last year the ECB was still singing along with Andrea True Connection.

More! More! More!

This particularly matters because it was expanding the money supply and easing fiscal policy into an inflation surge. So exactly the opposite of what it is supposed to do. We are back to expectations and forecasts again and the problems when you get them so wrong. Now we are told.

In December we will lay out the key principles for reducing the bond holdings in our asset purchase programme portfolio.

This is being forced on them because some of the holdings are getting expensive now. If you buy bonds and negative yields then paying 1.5% on them means you have a running cost of 2% per annum which will rise. Next on a mark to market basis there will be large losses in some cases. For example looking back on my chart the Italian bond future has lost 21% over the past year. The German one has lost 18%.

Central bankers around the world are looking at QT as they panic about the losses they have made and the running cost which in an irony is being made higher by their own actions.

Comment

The simplest issue here is the Bananarama critique of monetary policy.

It ain’t what you do, it’s the way that you do itIt ain’t what you do, it’s the way that you do itIt ain’t what you do, it’s the way that you do itAnd that’s what gets results

In essence they responded last and have done the least of the central banks which are raising interest-rates. This is a particular issue because monetary policy needs to act in advance ( at least a year) as it takes time to operate. Due to the move towards fixed-rate mortgages the lags have got longer. Actually the latter means that the ordinary person on the Frankfurt or Paris omnibus is better at forecasting than the central bankers.

Next up is the elephant in the room.

Additionally, although recent data on GDP growth have surprised on the upside, the risk of recession has increased.

Actually I think the Euro area is in recession but let us use our translator on what she has said. There is no cheerleading about the GDP growth so she doesn’t believe it either. Also mentions of “recession” by a central banker are not to forecast it they are there because they have been warned it has arrived and they need to cover themselves. Later she will claim to have been on the case and most will take that at face value.

Next up is the suggestion that the recession might last for quite a while.

At the same time, historical experience suggests that a recession is unlikely to bring down inflation significantly, at least in the short run.

This is reinforced by the fact that she is giving herself scope to blame others.

In the current environment of high inflation, fiscal policy needs to be temporary, targeted and tailored. It should be temporary, so that it does not push up demand too much over the medium term; targeted, so that the size of the fiscal impulse is limited and benefits those who need it most; and tailored, so that it does not weaken incentives to cut energy demand.

Considering how wrong she has been you might reasonably think she has quite a cheek telling others what to do…

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