The European Central Bank on Thursday signaled an end to its bond-buying stimulus program and said it would deliver its first interest rate hike since 2011 next month, followed by a potentially larger move in September.
The central bank for the 19 countries that use the euro currency said it would end quantitative easing on July 1, then raise interest rates by 0.25% on July 21.
The ECB will then raise interest rates again on September 8 and go for a bigger move — unless the inflation outlook has improved by then.
“We will make sure that inflation returns to our 2% target over the medium term,” ECB President Christine Lagarde said during a news conference.
“It is not just a step, it is a journey.”
With inflation at a record-high 8.1%, the ECB fears that price growth could develop into a wage-price spiral and usher in a new era of higher prices.
The ECB raised its inflation projections once again — now expecting inflation at 6.8% this year versus a previous forecast for 5.1%.
In 2023, the ECB sees inflation at 3.5% and in 2024 at 2.1%, indicating four straight years of inflation overshoots.
Lagarde said this is too nigh and said that a repeat of these projections three months from now would require quicker rate hikes.
“If you are at 2.1% in 2024 or beyond, then the increment of the adjustment will be higher? The answer is yes,” Lagarde said.
The ECB said in a statement: “In May inflation again rose significantly, mainly because of surging energy and food prices, including due to the impact of the war.
“But inflation pressures have broadened and intensified, with prices for many goods and services increasing strongly.
“Eurosystem staff have revised their baseline inflation projections up significantly. These projections indicate that inflation will remain undesirably elevated for some time.
“However, moderating energy costs, the easing of supply disruptions related to the pandemic and the normalisation of monetary policy are expected to lead to a decline in inflation.
“The new staff projections foresee annual inflation at 6.8% in 2022, before it is projected to decline to 3.5% in 2023 and 2.1% in 2024 – higher than in the March projections.
“This means that headline inflation at the end of the projection horizon is projected to be slightly above the Governing Council’s target.
“Inflation excluding energy and food is projected to average 3.3% in 2022, 2.8% in 2023 and 2.3% in 2024 – also above the March projections.
“Russia’s unjustified aggression towards Ukraine continues to weigh on the economy in Europe and beyond.
“It is disrupting trade, is leading to shortages of materials, and is contributing to high energy and commodity prices.
“These factors will continue to weigh on confidence and dampen growth, especially in the near term.
“However, the conditions are in place for the economy to continue to grow on account of the ongoing reopening of the economy, a strong labour market, fiscal support and savings built up during the pandemic.
“Once current headwinds abate, economic activity is expected to pick up again …
“The Governing Council decided to end net asset purchases under its asset purchase programme (APP) as of 1 July 2022.
“The Governing Council intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it starts raising the key ECB interest rates and, in any case, for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance.
“As concerns the pandemic emergency purchase programme (PEPP), the Governing Council intends to reinvest the principal payments from maturing securities purchased under the programme until at least the end of 2024.
“In any case, the future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance.
“In the event of renewed market fragmentation related to the pandemic, PEPP reinvestments can be adjusted flexibly across time, asset classes and jurisdictions at any time.
“This could include purchasing bonds issued by the Hellenic Republic over and above rollovers of redemptions in order to avoid an interruption of purchases in that jurisdiction, which could impair the transmission of monetary policy to the Greek economy while it is still recovering from the fallout from the pandemic.
“Net purchases under the PEPP could also be resumed, if necessary, to counter negative shocks related to the pandemic …
“The Governing Council undertook a careful review of the conditions which, according to its forward guidance, should be satisfied before it starts raising the key ECB interest rates.
“As a result of this assessment, the Governing Council concluded that those conditions have been satisfied.
“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.
“In the meantime, the Governing Council decided to leave the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility unchanged at 0.00%, 0.25% and -0.50% respectively.
“Looking further ahead, the Governing Council expects to raise the key ECB interest rates again in September.
“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.
“Beyond September, based on its current assessment, the Governing Council anticipates that a gradual but sustained path of further increases in interest rates will be appropriate.
“In line with the Governing Council’s commitment to its 2% medium-term target, the pace at which the Governing Council adjusts its monetary policy will depend on the incoming data and how it assesses inflation to develop in the medium term …”
REACTION:
Pietro Baffico, European Economist at Edinburgh-based asset management giant Abrdn: “As expected, the ECB revised both its forecasts and guidance in its June meeting, announcing an early end of the net QE purchases, ahead of the policy lift-off in July, with rates hiked by 25bps.
“The question for the second hike is not when, which will be in September, but how much, as it could be by 50bps depending on the updated medium-term inflation outlook.
“Unsurprisingly, the Governing Council did not yet detail the speed of subsequent policy adjustments, as it focused on the first step of this journey.
“While it leaned on the hawkish side, citing a gradual but sustained path, it highlighted its data-dependent approach.
“The German 10-year bond yields rose following the decision, while the euro initially lost some ground, as markets are still seeing a slower tightening than in US and UK.
“The forecast revised inflation up, and growth down.
“We agree with the ECB which sees ‘undesirably elevated inflation for some time’, at 6.8% in 2022, and to 3.5% in 2023.
“The outlook for the economy is at 2.8% in 2022, 2.1% in 2023, although we see risks for a weaker growth, which could prompt again the ECB to a more cautious stance in the future.
“President Lagarde repeated that stands ready to design and deploy new instruments to prevent fragmentation risks in the Euro Area if needed.
“However, she avoided entering into details on how a new tool could look like, suggesting that the verbal pledges and the reinvestment of QE purchases remains the preferred ECB option until sustained spreads on bond yields materializes.
“The risk for investors of bond spreads to widen remains in place.”
Hinesh Patel, portfolio manager at Quilter Investors: “The ECB has previously been well behind the curve when it comes to tightening policy, and to some extent it is holding fast still – though this finally looks to be coming to an end.
“Having previously provided little commitment to an end date, the ECB has now declared it intends to end asset purchases by July 1.
“Additionally, while no changes will be made to key interest rates this month, the ECB announced today that it intends to raise them by 25 basis points in July, with a further rise expected in September.
“Given the sharp rise in its inflation forecasts – which is now expected to reach 6.8% this year, up from the previous 5.1% estimate – as well as lower economic growth projections for the coming years, it is unsurprising the ECB has finally had to act.
“For now, the balancing act faced by the ECB continues to be a tricky one.
“The bloc is faced with inflationary shock that requires quick and decisive action, yet Russia’s ongoing attack on Ukraine continues to cast a shadow of uncertainty over Europe that could end with weak demand and recession.”
Commerzbank chief economist Jörg Krämer: “The ECB remains behind the curve …
“It is not enough to just take its foot off the gas, it must also step on the brakes.
“But that is precisely what it is not prepared to do, which is why we expect inflation to average well above 2% in the coming years.”
Anna Stupnytska, global macro economist at Fidelity International: “While the risk of de-anchoring in longer-term inflation expectations does not seem high, rapid widening in policy differentials versus the Fed does present challenges for the ECB, with EURUSD re-pricing in the spotlight.
“But doing too much too soon would arguably be a riskier strategy for the ECB in light of a weakening growth backdrop as well as the risk of peripheral spread fragmentation.”
Sandra Holdsworth, head of UK rates, Aegon Asset Management: “It gave a strong signal that more increases are to come in the future – in its words, ‘a gradual and sustained path of increases in interest rates’.
“It also highlighted the possibility of a larger increase in rates in September, making this meeting its most hawkish to date by far.”
Robert Alster, Close Brothers Asset Management: “Holding rates at minus 0.5% despite record inflation, the ECB looks late to the party compared to the Fed.
“The ECB does appear to be joining the ‘hike-brigade’ but we do not expect Europe to attempt to overtake the Fed. Rather, the ECB is simply following the US lead, and we do not expect more aggressive tightening whilst the war in Ukraine continues to weight on sentiment.”
Hetal Mehta, senior European economist, Legal & General Investment Management: “The central bank will hope that it will not need to construct another programme to support Italy.
“Persistently low yields over the last eight years have allowed the Italian Treasury to refinance existing debt at lower funding costs, significantly reducing its debt servicing costs and making its high debt burden more manageable.
“Higher ECB interest rates and Italian borrowing costs call into question Italian debt sustainability.”