Fearing high inflation, ECB to stay on course to unwind stimulus

By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) -The European Central Bank may outline on Thursday a clearer schedule for unwinding its extraordinary stimulus, as worries over record-high inflation trump concerns about a war-related recession.

The ECB has been reducing the pace of its money-printing programme for months but it has so far avoided committing to an end date for the scheme, worried that the war in Ukraine and sky-high energy prices could suddenly change the outlook.

It is lagging far behind most nearly all other major central banks, many of which started raising interest rates last year. In the past two days alone, the central banks of Canada, South Korea and New Zealand all raised the cost of borrowing. [TOP/CEN]

For now, the ECB plans to end bond purchases, commonly known as quantitative easing, at some point in the third quarter, with interest rates going up “some time” after that.

Approved last month, this loosely worded schedule is already being challenged as opposing forces leave the rate-setting Governing Council in a dilemma.

On the one hand, inflation is already at a record high 7.5%, with more increases still to come. On the other, the bloc’s economy is now stagnating, at best, with the impact of the war hurting both households and businesses.

“Given the high levels of uncertainty, (the ECB) will likely want to maintain the optionality and flexibility,” ABN Amro economist Nick Kounis said.

“However, the hawkish tone is likely to intensify, leaving no doubt that the most likely outcome in coming months is an end to net asset purchases and subsequently higher policy rates.”

Indeed, a host of conservative policymakers, including the central bank governors of Germany, the Netherlands, Austria and Belgium have all made the case for higher interest rates, worried that high inflation could linger too long.

Adding to the hawkish case, longer-term inflation expectations, a key gauge for the credibility of policy, have moved decisively above the ECB’s 2% target, even though wages have yet to respond to higher prices.

RATE HIKES?

So, although policy is expected to remain unchanged at Thursday’s meeting, ECB chief Christine Lagarde could come under pressure to signal more firmly that support will be rolled back in the coming months.

“Lagarde could hint at a conditional end of (asset) purchases in June, opening up the possibility of a first rate hike in September,” Pictet Strategist Frederik Ducrozet said. “Alternatively, she might just refrain from pushing back against market pricing, which is consistent with lift-off in September anyway.”

Lagarde contracted COVID-19 last week but said her symptoms were “reasonably mild”.

Markets now price in a combined 70 basis points of hikes in the ECB’s minus 0.5% deposit rate this year, even though not one of the ECB’s 25 policymakers have called for such aggressive tightening.

Fuelling policymakers’ caution is the economic outlook, which is deteriorating quickly.

High energy prices are draining household savings and the uncertainty of the war is halting corporate investment. Banks are also tightening access to credit as they naturally do during wars, potentially exacerbating the downturn.

Policy doves, meanwhile, argue that most of the inflation is a result of external supply shocks, so inflation will naturally fall over time.

In fact, high energy prices tend to be deflationary over the longer term because they hold back growth, so there is a risk of inflation falling too low.

“A key question is whether the flow of Russian energy to Europe will remain smooth. Should volume restrictions ensue, we would see a much-increased risk of a Eurozone recession, which would likely prompt the ECB towards greater caution,” UBS economist Reinhard Cluse said.

Still, weighing the two opposing forces, the ECB is likely to see greater risk from higher inflation, even if policymakers will continue to move in small increments, standing ready to change course on short notice.

(Editing by Toby Chopra and Kenneth Maxwell)