ECB echoes subtle change in central bank tone

The European Central Bank increased its policy rate by 75bp on Thursday, as expected, doubling the deposit rate to 1.5% and moving closer to the market’s current estimation of a 2% neutral rate. Alongside the policy move, the ECB also announced changes to the terms of its Targeted Long Term Refinancing Operation (TLTRO), increasing the rate it pays on minimum reserves to the deposit rate and allowing banks to repay these loans early. 

All of this was in line with our expectations and market consensus. Banks in Europe had essentially been eating a free lunch by borrowing from the ECB at the TLTRO rate of -1% and then parking that money back at the central bank at the deposit rate, so discussions on adjusting TLTRO terms had been in the works for a while.

The ECB did however offer hints as to the future path of interest rates in Europe. While it expects to undertake further rate increases to combat still too high inflation, the central bank’s statement did allude to a slower pace of hikes going forward. “With this third major policy rate increase in a row, the Governing Council has made substantial progress in withdrawing monetary policy accommodation,” it said, opening up the likelihood of a step down in the pace of hikes from 75bp to 50bp at the next meeting. 

In her press conference, the ECB chair Christine Lagarde reiterated the guidance on further hikes to come, and of course the fact that inflation is still very elevated, but she also added that the Governing Council is cognisant of the current downside risks to growth in the European economy. 

Notably, Lagarde’s comments echo those from other central banks in recent weeks. The Wall Street Journal’s Nick Timiraos – a closely followed Fed reporter – last  week reported that while a 75bp hike from the Fed is nailed on for the November 2 FOMC meeting, the committee is likely to debate “how to signal plans to approve a smaller increase in December” after what would be a fourth 75bp hike in a row. The Bank of Canada on Wednesday hiked by a smaller than expected 50bp, with its governor stating that they are “getting closer” to the end of the tightening cycle, though they are “not there yet.” Finally, the chief economist of the Bank of England, Ben Broadbent, in a speech last week said that the big increases in interest rates the market had priced in would deliver a “pretty material” hit to the economy.

As a result, terminal rate forecasts across developed markets have come in significantly over the past few weeks. Swap markets were predicting a peak Fed Funds rate of 5.1% last Thursday and are at 4.8% now, more or less in line with the Fed’s September dot plots. UK terminal rate forecasts peaked around 6.7% after the mini-Budget Gilt sell-off but are almost 200bp lower at 4.75% now, and in Europe terminal rate forecasts have moved from above 3% one week ago to just under 2.6% now.

While we expect central banks to remain hawkish in the face of still persistent inflation, we know that monetary policy also acts with “long and variable” lags. We would distinguish between this change in messaging and a ‘dovish pivot’ though, since the tone from the central banks remains very much ‘raise and hold’ rather than raising the prospect of any imminent cuts. Policymakers need to cautiously signal the change in messaging without engineering any financial loosening, which would reverse the impact of hikes, and of course they need to remain data-dependent.

Ultimately, as we move quickly through the hiking cycle and towards terminal rates, we would expect rates volatility to decline. Gradually increasing interest rate duration in this context makes sense, as well as moving up the ratings spectrum in credit as growth slows.