Yesterday turned out to be quite a day in central banking terms. There is much to say about my home one as in the Bank of England, but the truth is that even the extraordinary fantasy world that a couple of its policymakers apparently live in was quickly gazumped a couple of hours later by European Central Bank ( ECB) President Christine Lagarde. That has echoes of both 2011 and her “shock and awe” comments about a claimed Greek economic recovery that rapidly turned into a depression.
Things started calmly enough and were what we expected from the official announcement.
The Governing Council decided to raise the three key ECB interest rates by 50 basis points. Accordingly, the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will be increased to 2.50%, 2.75% and 2.00% respectively, with effect from 21 December 2022.
The one that is especially relevant is the deposit facility as it is the main player as you might expect fro its name. So the benchmark is now 2%. We also got something that is both a central banking standard and a little curious.
In particular, the Governing Council judges that interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictiveto ensure a timely return of inflation to the 2% medium-term target.
At this point “steady pace” could mean quite a few things, but the curious point is that we were being guided forwards not even 2 months after Forward Guidance had been formally abandoned.
So we are very much and deliberately turning our back to forward guidance, which is not helpful in the current circumstances given the level of uncertainty that we have pretty much all around. ( President Lagarde 27th of October)
Actually yesterday’s statement very quickly contradicted itself.
Our future policy rate decisions will continue to be data-dependent and follow a meeting-by-meeting approach.
So maybe not the steady pace we had just been told then.
The Press Conference
Things got much more heated here.
One of them is that we, at this point in time, expect and judge that we will have to raise interest rates significantly. Now, what does that mean?
Then steady pace was back.
You have to read it together with the steady pace.
Then it came back with what Americans call the money shot and the emphasis is mine.
It is pretty much obvious that, on the basis of the data that we have at the moment, significant rise at a steady pace means that we should expect to raise interest rates at a 50-basis-point pace for a period of time.
That went off like a bomb in financial markets with the only delay coming from people who could not believe we had just been told that several further 0.5% interest-rate increases could be expected. Some delayed hoping for something of a rebuttal or correction like what happened after she told us that the ECB was not there to “close bond spreads” which sent the Italian bond market into a tailspin back in the day.
Indeed the point got rammed home.
The second element that you have in this paragraph is the reference to a steady pace, so it’s significant, and it has to be a steady pace, which means that we have made progress over the course of the last few months, but we have more ground to cover. We have longer to go, and we are in for a long game.
As you can see the “steady pace” was the theme of the day which of course contradicts the “data-dependent” point. But it combined with the “long game” meany thoughts switched to how high ECB interest-rates were now expected to go. It provoked a question.
Investors currently expect a terminal rate of about 3%. Does that sound reasonable to you?
To which President Lagarde replied.
Our staff projections, that embed and incorporate the market expectations of our terminal rate, do not certainly allow a return to the 2% inflation target that we have in a timely manner.
So higher than a 3% interest-rate then. That has an issue because the ECB has guided people towards 2% being a “neutral rate” which led to the 3% expectations in the markets. Now we were being told this.
We are showing determination and resilience in continuing a journey where we have, if you compare – comparisons are odious, but if you were to compare with the Fed – we have more ground to cover. We have longer to go, and that is the reason why we have very specifically added messages in our monetary policy statement to reflect that fact.
So what does that mean?
that implies markets should price at least a 4.5% nominal ECB terminal rate. ( @MacroAlf )
I think that is a bit racy as it relies on the core inflation forecast being accurate but we were guided to 4%. As the Fresh Prince put it.
Boom! shake-shake-shake the roomBoom! shake-shake-shake the roomBoom! shake-shake-shake the room
Sauces
I described the ECB procedure for this on twitter before the event.
Next up is the ECB which I expect to increase interest-rates by 0.5% to 2%. Again I am expecting dissent but it is not as transparent as the Bank of England so we may have to wait until “sauces” leak to the media tomorrow…..
In fact they were quick off the mark.
ECB sources: More than one-third of ECB officials wanted to hike by 75 bps ( forexlive.com)
So rather than reigning back they added to it. This morning they have continued with the same theme.
ECB‘S REHN: 50 BPS HIKES ARE LIKELY IN FEBRUARY AND MARCH.
ECB‘S HOLZMANN: THE ECB TO GO DEEP INTO RESTRICTIVE TERRITORY IF NEEDED.
ECB‘S MULLER: INTEREST RATES MUST BE RAISED FURTHER. ( @financialjuice )
Financial Markets
Here is Alvise Armellini of Reuters with a response from the obvious impact point.
“I don’t understand the Christmas present President Lagarde has decided to give Italy,” Defence Minister @GuidoCrosetto
tweeted alongside a chart showing a widening yield spread between Italian and German government bonds.
In terms of numbers the ten-year yield of Italy gas risen by 0.5% to 4.4%. This is especially significant as I note this from a couple of days ago.
*EU WARNS ITALY HAS NOT MADE PROGRESS ON KEY FISCAL REFORMS ( @AlessioUrban )
With their other hand they have just made it harder.
Even Germany was hit and in essence fiscal policy across the Euro area just tightened. Germany for once will be especially hit if the story that it needs to borrow around 500 billion Euros to smooth its energy crisis turns out to be true.
As to equity markets well they took a dive too. The Dax of Germany has fallen by around 3%.
There should be relief on the Euro front and there was to some extent as it rose by 1% versus the UK Pound £ for example. But it still drifted lower versus the US Dollar as the change in expected interest-rate differentials was offset by the likely consequences.
Comment
The first point is the simply awful timing of the ECB and President Lagarde.
Lagarde December 2021: we see inflation as a hump & a hump eventually declines… inflation will decline over the course of 2022. ( @WalkerAmerica )
On that road she thought interest-rate rises were very unlikely where in reality she has ended up increasing them by 2.5%. Whereas now she is ramping up the rhetoric as there are signs inflation might be slowing.
The outlook for inflation is especially encouraging, with
supply chains now improving for the first time since the
pandemic began and firms’ costs growing at a sharply
reduced rate, feeding through to lower rates of increase for prices charged for both goods and services. ( S&P PMI )
That is backed up by a lower oil price for example and other supply costs.
So we have a classic central banking timing error which has exacerbated the inflation crisis and looks set to make next year;s slow down worse. This was what making central banks independent was supposed to avoid! But then they appointed politicians to the ECB…..
Next up is the issue of ramping bond yields just as Euro area countries have to borrow more because of the energy crisis. I can add in the future plans for QT bond sales although at the moment they are minor. It is rather a self-inflicted wound to add to the energy crisis and again to next year’s slow down.
I suppose though all of this is in keeping with someone who has a conviction for negligence.