By Francesco Canepa
FRANKFURT (Reuters) – The European Central Bank will stop pumping money into financial markets this summer, it said on Thursday, paving the way for an increase in interest rates as soaring inflation outweighs concerns about the fallout from Russia’s invasion of Ukraine.
With price growth in the euro zone at a record high even before Moscow began its assault on Feb. 24, the ECB was under pressure to at least stop adding fuel to the fire through its long-running asset-purchase programme.
While a handful of policy doves at Thursday’s meeting argued the war justified a pause for thought, they were outnumbered as worries about inflation, which hit a record 5.8% in February and is seen rising further, dominated the debate. [nL5N2VD6J3]
ECB President Christine Lagarde said the conflict was a “watershed for Europe”, which would curb growth but boost inflation.
“The Russia-Ukraine war will have a material impact on economic activity and inflation through higher energy and commodity prices, the disruption of international commerce and weaker confidence,” she said at a news conference.
But the waning impact of the coronavirus pandemic on the economy, improved labour market conditions and the prospect of an easing of supply chain bottlenecks all showed the euro area was in fundamentally healthy shape, Lagarde added.
While the bank announced modest growth downgrades for this year and next, it ramped up inflation forecasts more strongly and now expected price growth of 5.1% this year, 2.1% next year and 1.9% in 2024.
This fulfils the only outstanding condition that the ECB has set for its first rate hike in over a decade, namely that inflation is seen stable at its 2% target.
“Since the ECB now sees its inflation target effectively achieved, it is likely to raise its key interest rate twice this year, by 25 basis points each time,” Commerzbank (DE:CBKG)’s chief economist, Joerg Kraemer, said.
Indeed investors ratcheted up their bets on rate hikes after the ECB’s decision and now expect it to increase its rate on deposits by nearly 50 bps by the end of the year.
This would take it back to zero after eight years in which banks were charged for parking their idle cash at the ECB.
The bank confirmed plans to wrap up its 1.85 trillion euro Pandemic Emergency Purchase Programme at the end of the month and said purchases under the older and stricter Asset Purchase Programme (APP) will be smaller than previously planned.
It now expects APP purchases to total 40 billion euros in April, 30 billion euros in May and 20 billion euros in June. Previously it had set purchases at 40 billion euros in the second quarter, 30 billion euros in the third quarter and 20 billion euros in the fourth.
Bond buys in the third quarter will be “data-dependent”, the ECB said, adding that the schedule could still be revised if the inflation outlook changes.
It said any adjustments in interest rates would take place “some time” after the end of asset buys, a change from the previous formulation that purchases would end “shortly before” a rate move.
“Obviously ‘some time after’ is an open time horizon which is data dependent,” Lagarde said, when asked repeatedly what that meant for the timing of a first rate hike.
In a Reuters poll, nearly two-thirds of respondents said the APP would be shut by end-September, with nearly half saying it would be in that month.
Yet the move still came as a surprise to many investors, who expected the ECB to make as few commitments as possible, keeping options open until there is more clarity about the war.
But ECB staff forecasts published on Thursday showed that even in a severe scenario where stricter sanctions are imposed on Russia, euro zone inflation would come in at 1.9% in 2024.
“Contrary to the ECB staff, we can think of several adverse scenarios under which more ECB support will be needed,” Pictet’s strategist, Frederik Ducrozet, said.
The euro quickly firmed on the ECB decision, seen as a modest victory for conservative policymakers, and bond yields rallied.
Ten-year German yields rose about 7 basis points on the decision while the euro was trading at 1.108 versus 1.104 before the decision.
Markets now see around 43 bps worth of interest rate hikes this year, up from around 30 bps predicted before the meeting.
“All in all, today’s decisions are a good compromise, keeping maximum flexibility in a very gradual normalisation of monetary policy,” ING economist Carsten Brzeski said. “A first rate hike before the end of the year is still possible.”