What Can the ECB Do Now?

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What Can the ECB Do Now?

Tomorrow the ECB meets for its latest policy assessment. The consensus among economists is that there will be a hike of 75bps, and the market appears to be pricing it in. Therefore, the reaction in the currency pairs might be minimal, since over two-thirds of the surveyed economists agreed. Those who didn’t were split between 50bps and 100bps, with the midpoint at 75.

That means markets are likely to be looking beyond the current meeting, with expectations around what happens in December likely the key to how the pairs perform. The Euro has fallen respect to the dollar for two major reasons: The ECB has been much slower to raise rates, and inflation has gone higher in the shared economy. That means the real interest rate spread has continued to grow. With the Fed expected to raise rates another 75bps as well, the ECB has to keep pace in order to keep the Euro from falling. It would have to do something more than that to lift the shared currency.

What can make a stronger Euro?

The thing is, a stronger Euro would help the ECB reach its targets in the current circumstances. Almost half of the inflation experienced in Europe is because of the high price of fuel – which is priced in dollars. A stronger Euro would help reduce the impact of inflation from that source. It would also help reduce the cost of other imports. Of course, on the other hand, it would make exports more difficult, but the Euro is near lows it hasn’t seen for more than a couple of decades.

However, that’s unlikely to be a consideration for policy; merely a potential beneficial side effect. The ECB is dealing with another problem, and that is so called “excess liquidity”. Investors have been staying on the sidelines given the uncertainty in Europe. And considering how little bonds pay, they aren’t rushing to buy up debt. With inflation expected to remain high for an extended period of time, but interest rates not forecast to rise to compensate, it’s just not a sound investment to buy Eurobonds (compared to other currencies).

What to look out for

The ECB is expected to address this issue during the meeting, and look for another mechanism to mop up this “extra cash” that’s contributing to higher inflation. One of them is quantitative tightening, which is to sell bonds that the ECB has bought up. This would be expected to force up market interest rates, and encourage investors to take on more debt.

However, Lagarde has insisted this won’t happen until the ECB has reached its neutral rate, meaning it’s unlikely to be implemented just yet. However, a change in rhetoric around the possibility of QT – for example, that it’s not necessary to reach the neutral rate – might change the calculus of the market. It’s not likely to be enough to push the Euro substantially higher, but it could set the groundwork for that to happen later in the year.

The other option is to take a more definitive stance on what’s called the “terminal rate” or the rate at which the ECB will taper off hikes. So far, officials have talked about reaching 2.0% by the end of the year. With 75bps expected tomorrow, that means just 50bps in December. But if members were to talk about a higher terminal rate, it could get bond yields to rise as well. But, again, that would be more setting the groundwork for future actions, in a very uncertain environment.

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