The European Central Bank meets this week, and investors are waiting to see when the Frankfurt institution will begin to lower interest rates.
It is too early to declare victory in the struggle against inflation, but with inflation at a two-year low, the ECB’s Governing Council now has breathing room to focus on another critical issue: its massive balance sheet.
“Having reached its policy rate plateau at 4% deposit rate, the ECB can now shrink its balance sheet at a faster pace without risking too much of a blowout in yield spreads within the eurozone,” wrote Berenberg analyst Holger Schmieding in a research note to clients.
“Nonetheless, markets will probably have to correct some of their overoptimistic rate cut expectations once the ECB has spoken this Thursday.”
Inflation Has Plummeted
In November, inflation fell to 2.4%, while core inflation also fell. With inflation falling faster than expected, investors have increased their bets on the ECB cutting interest rates next year, especially after one of the board’s more hawkish members, Isabel Schnabel, described the consumer price slowdown as “remarkable” and “a pleasant surprise,” according to a transcript of a Dec. 1 interview with Reuters.
Rate cuts of around 150 basis points are currently priced in by money markets for next year. The bank’s key deposit rate has reached a new high of 4%, following a string of ten consecutive increases that began in July 2022 and moved rates back into positive territory for the first time since 2011.
“The risk now is earlier and larger cuts, as well as an ECB that is more capable of decoupling from the Fed,” said Mark Wall, an ECB analyst at Deutsche Bank.
However, he expects the ECB will keep its cards close to its chest: “We expect the ECB to maintain the guidance that maintaining restrictive rates for a sufficiently long period will bring inflation back to target promptly.”
Roll-off of PEPP
In March, there will be a new round of staff forecasts for inflation and economic growth. This will give the central bank more data to back up its policy approach, which is based on data, and could allow it to lower interest rates.
The ECB’s meeting on Thursday could lead to the biggest change in policy this week. It could be a shift in forward advice about when it will stop reinvesting in its PEPP program.
The Pandemic Emergency Buying Program (PEPP) is a flexible bond-buying program that was put in place during the coronavirus pandemic. When the ECB gets stocks from its PEPP portfolio that are about to mature, it reinvests them. But that could soon change.
“We have said that we will keep reinvesting until at least 2024,” ECB President Christine Lagarde told members in the European Parliament on November 27.
“This is a matter which will come probably for discussion and consideration within the Governing Council in the not-too-distant future, and we will reexamine possibly this proposal.”
Wall of Deutsche Bank said, “If rate cuts are moving forward, the ECB might speed up the first steps in the exit from PEPP reinvestments.”