MUFG: Attention shifts to ECB’s balance sheet as rate hike cycle comes to an end

24 oktober 2023

Looking ahead to next Thursday's ECB meeting, Henry Cook, Senior Economist at MUFG Bank, expects attention to shift from interest rates - where the hike cycle appears to be over - to the bank's balance sheet. Here is a summary of his expectations:

• The ECB raised interest rates by 25bp at the last meeting in September, taking total tightening to 450bp. It looks like a case of ‘job done’ now, at least when it comes to rate hikes. Last month’s move was accompanied by guidance suggesting that policymakers were ready for a pause ('rates have reached levels that … will make a substantial contribution to the timely return of inflation to target'). The minutes of the meeting suggest that it was already a close call to raise the deposit rate to 4%.
• Since the last meeting the evidence that core inflation pressures are easing has continued to mount and weakness in business surveys continues to point to faltering economic activity. There was no sign of any improvement in today’s flash PMIs with the composite euro area figure slipping to a 35-month low. The survey data suggests that the euro area economy is teetering close to recession in H2 this year. On top of that, the rise in long-term yields following increased investor buy-in to the ‘high for longer’ narrative will serve to strengthen the transmission of ECB monetary policy. This should help to quell lingering enthusiasm for any more immediate tightening action, even from the more hawkish members of the Governing Council.
• So there is little to justify further rate hikes. While it’s still too early to declare victory over inflation, the evidence of ongoing disinflation remains encouraging. On top of that, the clear indication from money and credit data is that the transmission of the ECB’s policy tightening is working, and working quickly. The latest ECB Bank Lending Survey, released today, showed a tightening of credit standards and weaker loan demand.
• Indeed, today’s PMI and bank lending survey data has shifted market expectations for this week’s ECB meeting slightly. Market participants are now pricing in a very small chance of a rate cut on Thursday, and very little tightening by year-end. The chance of further action on rates in December certainly seems slim. Looking ahead, we expect that the picture on inflation will continue to improve and concerns over euro area short-term growth prospects will remain high over coming months.
• Attention is now turning to the ECB’s balance sheet and the QT process. As it stands, reinvestments are due to continue until the end of 2024, but it’s widely expected that this date will be brought forward. Given the sell-off in bonds and extra pressure on Italian BTP spreads after signs of looser fiscal policy in Italy we doubt the ECB will be in a rush to officially change course at this meeting, but it’s something that could be mentioned (e.g. by Lagarde in the press conference). As it stands, PEPP reinvestments remain the first line of defence against fragmentation risks and some caution is warranted. The ECB may look to wind down reinvestments smoothly and predictably, as it did with the regular APP, with an average amount of balance sheet reduction each month.