ECB Preview: Meeting-by-meeting forward guidance

Summary:

• Underlying price pressures remain firm, with Euro area core inflation hitting a new high of 5.2% in December. We believe the European Central Bank (ECB) will hike policy rates 50 basis points at its February meeting, and indicate that it plans to raise interest rates further. We expect some guidance towards another 50 basis point rate hike in March, before a potential pivot towards moving in more traditional 25 basis point increments in May.
• We think the Governing Council (GC) will make clear that a restrictive policy setting might be warranted for longer than the market currently expects.
• The ECB will also release reinvestment reduction details, but we do not foresee any market moving surprises versus the broad principles released at its December meeting.

Additional thoughts:

Interest rates:

• Inflation data for December point to a persistent build-up of underlying price pressures even as energy price inflation has started to subside from high levels.
• The ECB remains concerned about wage dynamics, fiscal policy and market based financial conditions. After peaking in 2023, the ECB still expects growth in compensation per employee to be running at 3.9% year over year in 2025, well above its long-run average of 2.1%. Fiscal policy is seen as not targeted enough, and market based financial conditions might continue to encourage the ECB to maintain its hawkish posture, especially as the market prices rate cuts already in the second half of this year.
• If the recent underlying economic resilience of the Euro area persists, the prospect of the ECB having to tighten policy more than currently priced in financial markets might eventually come into sharper relief. For inflation to fully normalize back to the ECB’s 2% price stability target, some cooling in the economy and in the labor market is likely needed.

Reinvestment policy:

• The institutional Euro area setup suggests limited scope for the ECB to think about trade-offs between quantitative tightening (QT) and policy rates, arguing for any bond holding reduction exercise essentially taking the shape of a fairly mechanical background programme.
• The GC continues to view the set of policy rates as the primary monetary policy instrument, and President Lagarde even characterized balance sheet reduction as largely unrelated to the overall monetary policy stance.
• In December, the ECB laid out the key principles for reducing the bond holdings in its asset purchase programme (APP) portfolio. From the beginning of March onwards, the APP portfolio will decline as the Eurosystem will only partially reinvest the principal payments from maturing securities. The decline will amount to around €15bln per month on average until the end of the second quarter, and its subsequent pace will be determined over time.
• While the QT impact on the size of the ECB’s €7.96trn balance sheet and on excess liquidity will be modest near term, the main impact will be considerably higher bond issuance to the market, and we expect net European government bond supply to more than double this year.
• At the upcoming meeting the GC will announce the detailed parameters for reducing the APP holdings, and we do not expect any market moving surprises in those details. We expect the ECB to apply the overall reduction proportionately across the four APP portfolios, essentially by scaling down the reinvestments implied by the ECB’s existing approach by around 50%.

Framework review:

• At its December meeting the ECB mentioned that, by the end of the year, the GC will review its operational framework for steering short-term interest rates, which would provide information regarding the endpoint of the balance sheet normalisation process.
• In a recent speech, Executive Board member Schnabel added that the review of the ECB’s future operational framework would likely imply a larger steady-state balance sheet, potentially including a structural bond portfolio.
• In line with our long held view, this speaks to the ECB institutionalizing the current excess liquidity framework instead of reinstating the pre-global financial crisis benchmark allotment system.

Source: By Konstantin Veit, Portfolio Manager at PIMCO