ECB exit sequence fixed, pace more (but not fully) flexible

First of all, the Governor made it clear that the ECB is likely to follow the same sequence that has now become the gold standard of central banks around the world. He noted that the Governing Council thinks ‘that this gradual and sequential approach – first tapering, second lift off, and eventually downsizing – is appropriate’. This means that speculation that the ECB may hike its policy rate, while still continuing net asset purchases, is probably off the mark. Indeed, such a strategy seems to be equivalent to stepping on the gas and the breaks at the same time.

Mr Villeroy did however signal more flexibility on the pace of exit. He asserted that the Governing Council keeps ‘full optionality about the speed of this sequence, and will definitely be data driven’. This raises the question of whether the APP could be wound down faster than currently signalled in order to lay the ground for an early rate hike, as is currently the case with regards to the Fed’s exit.

The ECB’s forward guidance on the APP gives it some flexibility for later in the year, but not in the immediate future. The guidance on Q2 and Q3 purchases is not based on conditionality, the statement simply notes that the ‘Governing Council decided on a monthly net purchase pace of €40 billion in the second quarter and €30 billion in the third quarter under the APP’. The bar to reversing this decision would be high given that it was not framed as an ‘expectation’ or very explicitly ‘contingent on a certain development for inflation’.

However, beyond that, the statement notes that ‘From October 2022 onwards, the Governing Council will maintain net asset purchases under the APP at a monthly pace of €20 billion for as long as necessary to reinforce the accommodative impact of its policy rates. The Governing Council expects net purchases to end shortly before it starts raising the key ECB interest rates’. The first move in policy rates is of course contingent on certain inflation criteria being met.

This means that if the inflation criteria are met the ECB could wind down the APP in Q4. A rate hike could then follow theoretically in the first half of 2023. The definition of ‘shortly before’ of course gives it flexibility in that respect. At a push, it could be argued that the APP could end in October and a rate hike could come in December, but that really seems like stretching it, even if inflation turns out to be hitting or even exceeding the ECB’s target in its medium term projections.

The Governor’s speech did have a hawkish tone, not only because he was giving detail about the exit. It was also because he noted that the ECB ‘remains very vigilant about prices and wages dynamics, and will gradually adjust its monetary policy to firmly ensure that inflation recedes soon and then stabilizes around its 2% target over the medium term’.

Nevertheless, we judge Mr. Villeroy to be historically on the moderately hawkish wing of the Governing Council. In addition, it is very difficult to claim that there is a case for a speedy end to the APP and to hike rates on the basis of wage dynamics. Negotiated wage growth is closest to the lowest levels it has ever been. In addition, a decomposition of inflation, still suggests that inflation is mainly driven by energy, supply chain bottlenecks and post lockdown normalisation of services prices. Essentially there are few signs of second round effects. So we do not regard the quick exit scenario sketched above as being very likely.