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ECB Delay Presages Bigger Rate Increases in Coming Months

A new era is about to dawn. The euro area’s monetary authorities are finally set to become proactive in tackling soaring consumer prices — just not quite yet. The European Central Bank resisted the temptation to start its rate-hiking cycle at Thursday’s governing council meeting. But stalling until the July 21 gathering makes it more likely that once the first quarter-point increase is out of the way, September’s decision will see a half-point move that will take the benchmark deposit rate positive for the first time in eight years. Things move fast when the tide changes.

With consumer prices rising at an 8.1% annual pace in the euro area in May, there was an overriding need to signal that the fight against inflation begins here and now. President Christine Lagarde clearly is in peril of losing control of the governing council, so the hawks are demanding satisfaction. Delay now means they’ll just be demanding further and faster hikes later this year.

The ECB’s forward guidance has been affirmed; just 17 days ago, Lagarde said rates would rise first in July and again in September. The central bank repeated that pledge Thursday, adding that the inflation outlook will dictate the size of September’s change. With the ECB now predicting consumer-price increases will remain above its target in 2024, the backdrop argues for that move to take the deposit rate to 0.25%, up from -0.5% currently. Money markets are betting on 150 basis points of ECB rate hikes by year-end, which would entail two half-point and two quarter-point increases in the next four policy meetings.

Policy makers now face a delicate balancing act between trying to cap consumer prices without overly tightening financial conditions throughout the 19-nation euro area. The ECB’s 9 trillion-euro ($9.6 trillion) balance sheet is likely to contract significantly this year as it stops buying bonds. With additional bond purchases ceasing at the end of this month, attention inevitably will turn to when the ECB joins the Fed and BOE in at least passively letting its 5 trillion-euro portfolio run down as bonds mature. Thursday’s statement draws a distinction between the original Asset Purchase Program, which will continue for an unspecified “extended period,” and the already dormant pandemic program that will be fully reinvested until at least the end of 2024. As pressure builds for stimulus withdrawal, speculation will surely rise that at least the central bank could start quantitative tightening by halting reinvestment of redemptions sometime next year.

Banks have three opportunities this year to repay the super-cheap loans the ECB has afforded them, at rates as low as -1%, under its targeted long-term refinancing operations. As expected the special discounts available on those loans will be discontinued this month, bringing borrowing costs into line with the (soon-to-be-rising) official deposit rate. This will likely trigger a steady reduction over the rest of this year in the ECB’s balance sheet as commercial banks reassess their liquidity needs. That in turn risks slowing the availability of credit to the broader economy at the same time as the central bank is reducing its direct monetary stimulus.

Furthermore, curtailing quantitative easing will drive government borrowing costs up with peripheral nations suffering the most, even with an annual 440 billion euros of maturing holdings being reinvested automatically, according to estimates from NatWest Group Plc analysts. Italy’s 10-year spread to Germany has widened by 50 basis points since March; the nation’s benchmark yield has risen more than sixfold since August to 3.5%. With a debt-to-gross-domestic-product ratio of more than 150%, further increases in Italy’s financing costs will raise questions about its debt sustainability.

Pandemic stimulus has clearly been left in the financial system for too long and in too large a scale, a mistake made by central banks globally. But the ECB is last to wake up to the need to tap the brakes if the inflation monster is ever to be corralled, with more than 50 of its central-banking peers around the world already raising rates by at least half a point in single steps this year.

Of course, the euro economy needs to be carefully protected and looks more vulnerable more than most. Several members of the bloc, including Germany, are already verging on recession. It would be a catastrophic policy mistake to slide into a downturn, not least because it would be a tragic waste of the trillions of euros of monetary and fiscal pandemic support poured in over the past two years.

Actions really do speak louder than words, so the ECB needs to reaffirm its inflation-fighting credibility by driving its deposit rate into positive territory by the end of the third quarter. After that, life gets trickier; policy makers will need to be mindful of the risk of financial conditions suddenly overtightening.

More From Bloomberg Opinion:

• Even a Soft Landing Can Be Ugly for Investors: John Authers

• Central Bankers Don’t Know How to Tackle Inflation: Mark Gilbert

• Memo to Fed: Hurry Up and Hike So We Can Slow Down: Daniel Moss

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.

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