Dr Samy Chaar is Chief Economist of Lombard Odier Group & Cie in Geneva. In view of the rising inflation and looming growth outlook in the Eurozone, we were glad to have a timely talk with him on the latest decisions of the European Central Bank (ECB). Was the Bank right to raise its interest rates by 75 basis points at its latest meeting on October 27th while announcing a more measured pace of policy tightening?
Q.1: The European Central Bank (ECB) has decided, at the last meeting of the Governing Council on October 27th, to raise its interest rates by 75 basis points (bp). Do you think this decision was appropriate in view of the looming risks of recession in many Euro area economies?
The ECB has just delivered its first non-hawkish statement in months. Thursday’s 75 bp rate rise confirmed that it is “front-loading” its rate hikes to reach the “neutral range”, estimated to be just above 2%, rather quickly. Then, the ECB should revert to a more measured pace of tightening in December, with a 50 bp hike. This is because recession risks loom and because the inflation outlook will have marginally improved considering falling gas prices and limited wage pressures. Overall, the decision was broadly appropriate as it considers risks and enables some kind of debate on the orientation of monetary policy in a context that is difficult to manage.
Q.2: How high do you see rates going up in the euro zone and in which time frame?
When the ECB staff will update its macroeconomic projections in December, I would expect it to downgrade the growth outlook further and to show inflation returning to the ECB’s 2% target by 2025. This would argue decisively in favour of a pause in rate hikes in 2023 at levels north of the estimated neutral range. President Lagarde’s reference to the lag between monetary tightening and its impact on the economy will be an important part of future tightening decisions. A terminal rate of 2.25% may be enough for the ECB to approach its 2% inflation target by 2025. This rate could possibly be even lower with the use of some “quantitative tightening”. In contrast, markets expect a terminal rate of almost 3%.
Q.3: Are you concerned that the Euro area policy-mix is not appropriate at the moment? If not, how would you advise to make it more supportive of growth while having it tame inflation across eurozone economies?
The European fiscal packages, taken together, have a very different structure than a proper fiscal stimulus that pushes in the opposite direction from monetary tightening. They are actually reallocating the energy hit from private balance sheets to public balance sheets, and, in the process, keep energy prices contained. As a result, they are likely to bring inflation lower rather than higher (given how big a driver energy is). This is really different than stimulating demand by sending checks or cutting taxes, for example. As such, I do not feel that national governments are working in an opposite direction to the ECB. I would like to see more fiscal ambition to increase investments to grow energy capabilities in Europe. I would see this as needed productive investments, with little economic downside.
Q.4: How do you feel about the absence of quantitative tightening decisions (i.e. the reduction of the ECB’s overall balance sheet)?
The absence of “quantitative tightening” announcements at the last meeting is another rather “dovish” element (on top of the mention of the “lag effects”). The level of urgency does not seem overly high at present and therefore a roadmap is only likely to be laid out at the December meeting with a start sometime in early 2023. Quantitative tightening will concern the “asset purchase programme” (APP) portfolio. On the other hand, the ECB will be keen to avoid fragmentation risks, with the “transmission protection instrument” (TPI) activation in the background to manage any unwarranted fragmentation, even if questions about the “trigger points” (i.e. when and how the instrument would be deployed) and consistency with the inflation objection remain. Overall, this means that quantitative tightening will be for the APP portfolio and that it should be a passive and gradual process. The maturing bonds from the “pandemic emergency purchase programme” (PEPP) portfolio will be reinvested until at least the end of 2024 (as currently signaled).
