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ECB doves disheartened by plans to hasten pace of rate rises

Dovish rate setters at the European Central Bank leave their Amsterdam meeting unsatisfied after record inflation forced them to make concessions on the pace of rate hikes in the coming months.

“My impression is that everyone has lost their way,” said a wimpy board member about Thursday’s decision. That meant the ECB indicated it would likely raise its benchmark deposit rate above zero by the fall — faster than investors expected — to tackle inflation, which at 8.1 percent is now four times the bank’s target of 2 percent.

The councilor said the ECB had achieved the worst possible outcome; government borrowing costs rose, particularly for weaker southern European countries like Italy, while the euro fell nearly 1 percent against the dollar, fueling inflationary pressures by raising import costs. The dovish rate-setter added, “This is not what you want.”

The more cheerful hawks of the congregation see things differently. “It went well. We finally decided to take action against inflation, so I am very satisfied,” said a rate setter from this camp.

In fact, the deal, which was drafted by ECB chief economist Philip Lane, meant that both sides made concessions.

After having dinner together on Wednesday evening under Rembrandt’s painting of The Night Watch In the Rijksmuseum with the Dutch King and Queen Willem-Alexander and Máxima, Prime Minister Mark Rutte and Minister of Finance Sigrid Kaag, the council met again on Thursday to unanimously support the compromise.

The hawks agreed to backtrack on their push for the central bank to end its eight-year negative-rate experiment next month in one fell swoop via an aggressive half-percentage-point hike in deposit rates from its current minus 0.5 percent level. .

Instead, the ECB said it plans to raise interest rates by 25 basis points in July. But in return, the hawks won a pledge that the ECB would raise interest rates by “a bigger step” in September, as long as the inflation outlook “continues or deteriorates”. As inflationary pressures are likely to continue mounting for several months to come, most investors assume that means a 50bp hike in three months’ time is highly likely.

Showing that the hawks are now feeling more prominent, several said they hadn’t completely given up on the possibility of a 50 basis point gain in July, especially if euro-zone inflation rises above expectations again when it hits the new data will be announced at the end of this year. month. The ECB declined to comment.

Government borrowing costs rose in response to this week’s aggressive shift. The German 10-year yield rose by 0.08 percentage point to 1.43 percent. Riskier debt sold more sharply, with Italy’s 10-year yield rising 0.24 percentage point to 3.61 percent.

The line graph of the spread between Italian and German 10-year government bond yields widens and shows that a gap exists

Some investors were disappointed that the ECB did not make a clearer commitment to launch a new bond-buying program if necessary to avoid another debt crisis in highly indebted southern European countries such as Italy.

The issue was discussed at this week’s meeting and councilors agreed that ECB President Christine Lagarde would use her press conference on Thursday to highlight their willingness to launch a new tool at short notice if necessary to tackle the fragmentation in the euro-zone bond markets, the report said. one person involved in the discussions.

A severe “fragmentation” in member countries’ borrowing costs would mark a return to the days before the ECB started buying bonds in 2014 – a time when the threat of a debt crisis in more vulnerable member states risked leading to a breakup of the currency Area.

But most councilors agreed that there was no point in trying to design a new tool to address this risk until it became a reality, as it could be blocked by the ECB’s own lawyers for not being “proportionately or could pose a challenge to the German constitutional court.

Battle lines are already being drawn over the next controversial issue: how soon are we going to start shrinking the ECB’s balance sheet. At present, the intention is to continue reinvesting the proceeds from the €4.9 trillion securities portfolio as they mature. The hawks want this to end sooner or later, following the lead of the US Federal Reserve and the Bank of England.

Analysts say it will become increasingly difficult for the ECB to justify keeping its balance sheet stable, while also trying to contain record inflation by raising interest rates. Katharina Utermöhl, senior economist for Europe at Allianz, said that if high inflation were to raise interest rates, “shortening the reinvestment horizon” also seemed necessary.

Some councilors believe that if the ECB raises its deposit rate, it risks driving short-term borrowing costs above long-term rates, especially if it suppresses long-term yields by reinvesting the proceeds of maturing bonds.

This could create an inverted yield curve, with short-term borrowing costs higher than longer-term, making life difficult for banks that want to borrow short and borrow long – and make a profit on the difference. The risk of yield curve inversion could put pressure on the ECB to start shrinking its balance sheet before the end of this year.

But other rate-setters said there would be many factors determining when the ECB’s balance sheet should begin to contract — a process known as quantitative tightening — including the pace of inflation, the state of the economy and overall government debt levels. “I don’t think we’ll see this happen anytime soon,” the friendly councilor said.

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