Yesterday was always going to be an awkward day for the ECB as it faced up to the contradictions in its circumstances. In simple terms we have an organisation which has not raised interest-rates for more than a decade because of fears for what that would do to the Euro area economy finding itself facing market expectations of a 1.5% increase by the end of this year. That is six standard moves of 0.25% or more likely also some moves of 0.5% as I am not sure there are six meetings left this year. Quite a shock for an organisation that plunged into the icy cold world of negative interest-rates in 2015 and has only swum deeper into it since.
The response was very curious and I have not seen anyone else call it out in this way. So let me start with the announcement.
Accordingly, and in line with the Governing Council’s policy sequencing, the Governing Council intends to raise the key ECB interest rates by 25 basis points at its July monetary policy meeting.
The first issue is that the ECB has told us in the past that it does not pre-commit on monetary policy. Whereas it quite plainly did so yesterday. But the more important issue is that as it takes time for monetary policy to work as President Lagarde explained in the press conference then you should act now rather than in a month or so. In a way it is kind of them to make me look good as I have argued for many years that they will dither and delay in raising interest-rates. Which is exactly what they have done over the past year with another month added yesterday.
The issue here is partly that they have got themselves in a mess over how to end QE bond purchases and the order in which that stops and interest-rates rise.
The Governing Council decided to end net asset purchases under its asset purchase programme (APP) as of 1 July 2022.
So they have chosen procedure over substance when they could have announced both yesterday.
But there is more and it is even more damning.
Looking further ahead, the Governing Council expects to raise the key ECB interest rates again in September.
So if you expect to raise them in July and September then you obviously should raise them now. Indeed we have an odd situation where they promised a larger rise in September and the emphasis is mine.
The calibration of this rate increase will depend on the updated medium-term inflation outlook. If the medium-term inflation outlook persists or deteriorates, a larger increment will be appropriate at the September meeting.
So 0.5% in September as well giving us a total of 0.75% in the future but none now. With the leads and lags in the system this is nonesence as you should raise now by the 0.5%. Indeed President Lagarde explained the logic in a reply to a question in the press conference..
Now, typically monetary policy decisions have a longer-term impact in relation to inflation itself, so we have to stay the course, be determined, committed to delivering the 2%, but we cannot expect that to happen on the 22 July for a decision that we would have made in July.
Actually she precommitted even more as well.
And then we go further because we take a third step along that journey to indicate what we will do beyond September, which is also the anticipation that further rate hikes will be necessary on the basis of the data that we collect.
So we have a couple of steps here. The first is simply that if you think you will have to raise for the rest of the year why not start now? It seems obvious that they are hoping something will change and they will not have to.Also they have completely U-Turned on the issue of precommitting on interest-rates.
It was kind of President Lagarde to confirm a point I have made on here many times.
Your point number two is: why not 50 [basis points] in July? Well, we are coming out of 11 years of no interest rate move.
What about Italy?
We can now switch perspectives because the planned moves above create a bit problem for the weaker economies in the Euro area and that points an arrow at Italy. As I pointed out on Monday Italy has the largest national debt in the Euro area. Those who follow my “Girlfriend in a Coma” analysis over the years will know that the major cause of this has been lack of economic growth. According to the ECB that is about to be an issue again.
Compared with the March projections, the outlook has been revised down significantly for 2022 and 2023, while for 2024 it has been revised up.
Care is needed here because the 2024 upgrade is simply not to frighten people too much as let’s face it everyone will have forgotten it by then anyway. So the Euro area economy will be weaker which again makes investors wonder about Italy. After all it has yet to regain pre pandemic levels and GDP only rose by 0.1% in the first quarter. So apparently economic growth is going to pick-up in the face of all the energy price rises and falls in real wages? I am sure you can all see the flaw in that.
Whilst the press conference was continuing the situation was highlighted by this part of a question in the press conference.
We are today experiencing a new sell-off in sovereign bonds, and this might point that the PEPP reinvestments, maybe the ECB new commitment, is not enough to prevent fragmentation.
Again the focus is on Italy because whilst Germany will not want to pay 1.4% rather than 1.3% on its benchmark ten-year yield the big picture changes by only a minor amount. Whereas Italy was seeing this.
#ITALY BONDS EXTEND SLIDE AS LAGARDE SPEAKS; 10Y YIELD UP 20BPS – BBG……….#ITALY–#GERMANY BOND YIELD SPREAD RISES TO HIGHEST SINCE MAY 2020 – BBG ( @C_Barraud )
As you see the rise in Italian yields was higher which is in essence the fragmentation point. In purist terms if you have the same monetary authority the yields should be the same. They are not because investors would rather have a piece of paper with Germany stamped on it rather than Italy which is the problem.
The response of PEPP flexibility on reinvestments was clearly much less than hoped for in Italian markets. In essence as a stereotype a German bond maturing can be reinvested into an Italian one and as we looked at on Monday they can also do it before the German bond matures. But say a 50 billion or even a 100 billion Euro boost frankly seems to have been dismissed.
Comment
To add to the problems above there was an issue with the presentation as it became ever more obvious that President Lagarde had been told to stick to the script. Presumably to reduce the risk of another “we are not here to reduce bond spreads” remark from her. I assume this was a quid pro quo in return for her being allowed to say the votes were unanimous. Although she did let her guard down on the subject of a neutral interest-rate by denying any discussion then specifying it!
I am sure that we will ad nauseum argue as to whether it is 0.96 or 1.97 or beyond, or below or whatever.
So there is debate over that too.
All this saw the Euro fall to 1.06 versus the US Dollar completing what was a sorry mess. It has got even more confused this morning as this is one of the people most keen on a 0.5% increase in September.
ECB’S HOLZMANN: SEPTEMBER RATE WILL BE AT LEAST 25BPS BUT COULD BE 50 OR SOMETHING IN BETWEEN. ( @FinancialJuice )
So 0.375% or 0.4%?