ECB may have to restrict growth to control inflation – Christine Lagarde, President of the European Central Bank, stated that the European Central Bank will continue to raise interest rates and may need to limit economic activity to tame inflation. She said this on Friday, citing rates as the key instrument for balance sheet reduction.
To combat inflation, the ECB raised rates by 200 basis points in July. It also stated that it will continue to tighten its policy via rate increases and a reduction of its debt holdings of 5 trillion euros ($5.2 trillion).
Lagarde stated that “We expect to increase rates further – and withdrawing accommodations may not be sufficient,” during a speech at a conference.
She stated that interest rates were, and will continue to be, the primary tool for adjusting our policy position. “Acknowledging the fact that interest rates are still the most effective tool to shape our policy stance,” she said, “It is appropriate that the balance sheet be normalized in a measured but predictable manner.”
The ECB’s 1.5% deposit rate is close to the neutral rate. This is where the bank is neither encouraging nor stopping growth. The neutral rate is usually between 1.5% to 2% according to most estimates. This suggests that the bank will no longer be able “accommodate” growth after the December hike.
Problem is that inflation is at 10.6% which is well above the ECB’s 2% target. Even a recession, which is almost certain in the winter months, will not ease price pressures enough for the ECB to take the brakes.
Investors now have a choice between pricing a 50 or 75 basis-point increase in December following back-to-back 75 base point moves. They also see the reduction in bond holdings, also called quantitative tightening. This will occur in the first half 2023.
In December, the ECB will present plans to reduce its balance sheet. The process is expected to begin with the bank allowing some bonds to expire, but not all.
Lagarde stated that the ECB would ensure that a period of high inflation doesn’t feed into inflation expectations and allow too-high inflation become entrenched.