On Thursday, all focus was on ECB apart from the growing bank crisis on both sides of the Atlantic (U.S.-Europe). On Thursday ECB hiked all key policy rates by +0.50% as highly expected; i.e. reference interest rates on the main refinancing operations (interbank rate) to +3.50%; interest rates on the marginal lending facility (MLF-repo rate) to +3.75%, and interest rate on deposit facility (DRF-reverse repo) to +3.00%. Despite the concern about global/local financial stability, ECB goes for a +0.50% rate hike against some market expectations of +0.25% or even a pause.
As a result, EURUSD edged up briefly to around 1.06200, but soon slips to the session low of 1.05500 as unlike previous occasions, ECB doesn’t mention future/next plan of rate action/hike; i.e. there is no written forward guidance in the statement. But overall, ECB seems less concerned about ‘American’ regional/small bank failure (SVB) and also didn’t mention anything specific about Credit Suisse (CS) crisis, maybe CS is a concern of SNB/Swiss authority, which is not a Eurozone country/state and have different monetary authority/central bank (SNB).
In any way, ECB assured it has different tools to ensure price stability (interest rate hikes and QT), while also having various current/COVID-era liquidity injection tools to ensure financial stability. And ECB also made it clear that those two goals; i.e. price and financial stability have no conflict/trade-off. Thus ECB may continue to go for rate hikes in a data-dependent manner, even at a slower 25 bps pace in the coming months for an appropriate restrictive monetary policy/rate regime to ensure 2% inflation targets, while dealing with any potential issue of financial stability (bank failure/crisis) effectively with liquidity tools.
ECB also pointed out that, unlike the 2008 era, this time EU banking system is much more resilient/robust with BASEL-III regulatory capital requirement and under strict regulatory supervision, whereas, in the U.S., there may be some deficiencies with smaller banks. In any way, ECB is also watching current market tensions (banking crisis on both sides of the Atlantic) closely and is ready to respond with appropriate policy tools (including the TPI-backdoor YCC tool) to preserve both financial and price stability in the Euro Area.
Full Text of ECB statement: Monetary policy decisions: 16th March’2023
“Inflation is projected to remain too high for too long. Therefore, the Governing Council today decided to increase the three key ECB interest rates by 50 basis points, in line with its determination to ensure the timely return of inflation to the 2% medium-term target. The elevated level of uncertainty reinforces the importance of a data-dependent approach to the Governing Council’s policy rate decisions, which will be determined by its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.
The Governing Council is monitoring current market tensions closely and stands ready to respond as necessary to preserve price stability and financial stability in the euro area. The euro area banking sector is resilient, with strong capital and liquidity positions. In any case, the ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy.
The new ECB staff macroeconomic projections were finalized in early March before the recent emergence of financial market tensions. As such, these tensions imply additional uncertainty around the baseline assessments of inflation and growth. Before these latest developments, the baseline path for headline inflation had already been revised down, mainly owing to a smaller contribution from energy prices than previously expected.
ECB staffs now see inflation averaging 5.3% in 2023, 2.9% in 2024, and 2.1% in 2025. At the same time, underlying price pressures remain strong. Inflation excluding energy and food continued to increase in February and ECB staff expect it to average 4.6% in 2023, which is higher than foreseen in the December projections. Subsequently, it is projected to come down to 2.5% in 2024 and 2.2% in 2025, as the upward pressures from past supply shocks and the reopening of the economy fade out and as tighter monetary policy increasingly dampens demand.
The baseline projections for growth in 2023 have been revised up to an average of 1.0% as a result of both the decline in energy prices and the economy’s greater resilience to the challenging international environment. ECB staff then expects growth to pick up further, to 1.6%, in both 2024 and 2025, underpinned by a robust labor market, improving confidence, and a recovery in real incomes. At the same time, the pick-up in growth in 2024 and 2025 is weaker than projected in December, owing to the tightening of monetary policy.
Key ECB interest rates
The Governing Council decided to raise the three key ECB interest rates by 50 basis points. Accordingly, the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will be increased to 3.50%, 3.75%, and 3.00% respectively, with effect from 22 March 2023.
Asset purchase programme (APP) and pandemic emergency purchase programme (PEPP)
The APP portfolio is declining at a measured and predictable pace, as the Eurosystem does not reinvest all of the principal payments from maturing securities. The decline will amount to €15 billion per month on average until the end of June 2023 and its subsequent pace will be determined over time.
As concerns the PEPP, the Governing Council intends to reinvest the principal payments from maturing securities purchased under the programme until at least the end of 2024. In any case, the future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance.
The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic.
Refinancing operations
As banks are repaying the amounts borrowed under the targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted lending operations are contributing to its monetary policy stance.
***
The Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation returns to its 2% target over the medium term and to preserve the smooth functioning of monetary policy transmission. The ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed. Moreover, the Transmission Protection Instrument is available to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across all euro area countries, thus allowing the Governing Council to more effectively deliver on its price stability mandate.”
Text of the opening statement by ECB President Lagarde: 16th March’2023
“Inflation is projected to remain too high for too long. Therefore, the Governing Council today decided to increase the three key ECB interest rates by 50 basis points, in line with our determination to ensure the timely return of inflation to our two per cent medium-term target. The elevated level of uncertainty reinforces the importance of a data-dependent approach to our policy rate decisions, which will be determined by our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.
We are monitoring current market tensions closely and stand ready to respond as necessary to preserve price stability and financial stability in the euro area. The euro area banking sector is resilient, with strong capital and liquidity positions. In any case, our policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed and to preserve the smooth transmission of monetary policy.
The new ECB staff macroeconomic projections were finalized in early March before the recent emergence of financial market tensions. As such, these tensions imply additional uncertainty around the baseline assessments of inflation and growth. Before these latest developments, the baseline path for headline inflation had already been revised down, mainly owing to a smaller contribution from energy prices than previously expected.
ECB staffs now see inflation averaging 5.3 percent in 2023, 2.9 percent in 2024, and 2.1 percent in 2025. At the same time, underlying price pressures remain strong. Inflation excluding energy and food continued to increase in February and ECB staff expect it to average 4.6 percent in 2023, which is higher than foreseen in the December projections. Subsequently, it is projected to come down to 2.5 percent in 2024 and 2.2 percent in 2025, as the upward pressures from past supply shocks and the reopening of the economy fade out and as tighter monetary policy increasingly dampens demand.
The baseline projections for growth in 2023 have been revised up to an average of 1.0 percent as a result of both the decline in energy prices and the economy’s greater resilience to the challenging international environment. ECB staffs then expect growth to pick up further, to 1.6 percent, in both 2024 and 2025, underpinned by a robust labor market, improving confidence, and a recovery in real incomes. At the same time, the pick-up in growth in 2024 and 2025 is weaker than projected in December, owing to the tightening of monetary policy.
I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions.
Economic activity
The euro area economy stagnated in the fourth quarter of 2022, thus avoiding the previously expected contraction. However, private domestic demand fell sharply. High inflation, prevailing uncertainties, and tighter financing conditions dented private consumption and investment, which fell by 0.9 percent and 3.6 percent respectively.
Under the baseline, the economy looks set to recover over the coming quarters. Industrial production should pick up as supply conditions improve further, confidence continues to recover, and firms work off large order backlogs. Rising wages and falling energy prices will partly offset the loss of purchasing power that many households are experiencing as a result of high inflation. This, in turn, will support consumer spending.
Moreover, the labour market remains strong, despite the weakening of economic activity. Employment grew by 0.3 percent in the fourth quarter of 2022 and the unemployment rate stayed at its historical low of 6.6 percent in January 2023.
Government support measures to shield the economy from the impact of high energy prices should be temporary, targeted, and tailored to preserve incentives to consume less energy. As energy prices fall and risks around the energy supply recede, it is important to start rolling back these measures promptly and in a concerted manner. Measures falling short of these principles are likely to drive up medium-term inflationary pressures, which would call for a stronger monetary policy response.
Moreover, in line with the EU’s economic governance framework and as stated in the European Commission’s guidance of 8 March 2023, fiscal policies should be oriented towards making our economy more productive and gradually bringing down high public debt. Policies to enhance the euro area’s supply capacity, especially in the energy sector, can help reduce price pressures in the medium term. To that end, governments should swiftly implement their investment and structural reform plans under the Next Generation EU programme. The reform of the EU’s economic governance framework should be concluded rapidly.
Inflation
Inflation edged down to 8.5 percent in February. The decline resulted from a renewed sharp drop in energy prices. By contrast, food price inflation increased further, to 15.0 percent, with the past surge in the cost of energy and of other inputs for food production still feeding through to consumer prices.
Moreover, underlying price pressures remain strong. Inflation excluding energy and food increased to 5.6 percent in February and other indicators of underlying inflation have also stayed high. Non-energy industrial goods inflation rose to 6.8 percent in February, mainly reflecting the delayed effects of past supply bottlenecks and high energy prices. Services inflation, which rose to 4.8 percent in February, is also still being driven by the gradual pass-through of past energy cost increases, pent-up demand from the reopening of the economy, and rising wages.
Wage pressures have strengthened on the back of robust labor markets and employees aiming to recoup some of the purchasing power lost owing to high inflation. Moreover, many firms were able to raise their profit margins in sectors faced with constrained supply and resurgent demand. At the same time, most measures of longer-term inflation expectations currently stand at around two percent, although they warrant continued monitoring, especially in light of recent volatility in market-based inflation expectations.
Risk assessment
Risks to the outlook for economic growth are tilted to the downside. Persistently elevated financial market tensions could tighten broader credit conditions more strongly than expected and dampen confidence. Russia’s unjustified war against Ukraine and its people continues to be a significant downside risk to the economy and could again push up the costs of energy and food. There could also be an additional drag on euro area growth if the world economy weakened more sharply than expected. However, companies could adapt more quickly to the challenging international environment and, together with the fading-out of the energy shock, this could support higher growth than currently expected.
The upside risks to inflation include existing pipeline pressures that could still send retail prices even higher than expected in the near term. Domestic factors, such as a persistent rise in inflation expectations above our target or higher than anticipated increases in wages and profit margins, could drive inflation higher, including over the medium term. Moreover, a stronger-than-expected economic rebound in China could give a fresh boost to commodity prices and foreign demand.
The downside risks to inflation include persistently elevated financial market tensions that could accelerate disinflation. In addition, falling energy prices could translate into reduced pressure from underlying inflation and wages. A weakening of demand, including owing to a stronger deceleration of bank credit or a stronger than the projected transmission of monetary policy, would also contribute to lower price pressures than currently anticipated, especially over the medium term.
Financial and monetary conditions
Market interest rates rose considerably in the weeks following our last meeting. But the increase has strongly reversed over recent days in the context of severe financial market tensions. Bank credit to euro-area firms has become more expensive. Credit to firms has weakened further, owing to lower demand and tighter credit supply conditions. Household borrowing has become more expensive as well, especially owing to higher mortgage rates. This rise in borrowing costs and the resultant decline in demand, along with tighter credit standards, have led to a further slowdown in the growth of loans to households. Amid these weaker loan dynamics, money growth has slowed sharply, driven by its most liquid components.
Conclusion
Summing up, inflation is projected to remain too high for too long. Therefore, the Governing Council today decided to increase the three key ECB interest rates by 50 basis points, in line with our determination to ensure the timely return of inflation to our two per cent medium-term target. The elevated level of uncertainty reinforces the importance of a data-dependent approach to our policy rate decisions, which will be determined by our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. We are monitoring current market tensions closely and stand ready to respond as necessary to preserve price stability and financial stability in the euro area.
In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission.”
The major difference between Mar’23 and Feb’23 ECB/Lagarde statements is in terms of clear forward guidance. In the Feb’23 statement, the para related to current and future rate hikes was:
“Summing up, the Governing Council will stay the course in raising interest rates significantly at a steady pace and in keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to our two percent medium-term target. Accordingly, we today decided to raise the three key ECB interest rates by 50 basis points and we expect to raise them further. In view of the underlying inflation pressures, we intend to raise interest rates by another 50 basis points at our next monetary policy meeting in March and we will then evaluate the subsequent path of our monetary policy.”
Although ECB refrained from any specific forward (rate action) guidance in Mar’23 statement amid the concern of financial stability, ECB also said in the Feb’23 statement that after the Mar’23 hike of another +50 bps, ECB/GC will evaluate the subsequent path of monetary policy in a data-dependent manner to bring inflation to +2% target over the medium term.
Highlights of Lagarde’s comments during Q&A (Presser): 16th March’2023
· Inflation is projected to remain too high for too long
· The labour market is robust
· The economy will recover in the coming quarters, Industrial production should pick up
· The ECB forecasts were finalized in early March
· Government energy assistance should be temporary and targeted; otherwise, it will cause more elevated inflation and ECB has to do more tightening
· Underlying price pressures remain intense
· The majority of long-term inflation forecasts/expectations hover around 2%, these warrant continued monitoring in light of recent volatility
· Wage pressures have increased; companies/producers now have more pricing power-causing elevated inflation
· Services inflation caused by previous energy price increases
· Risks to the growth outlook are tilted to the downside
· A stronger China could provide a bigger boost to commodity prices and inflation
· Long-term geopolitical (Russia-Ukraine) tensions are a risk of inflation
· Tensions in the financial market have been extreme and may also cause disinflation
· I’ve noticed a further slowing in loan growth for households
· If the baseline persists as uncertainty decreases, there will be a lot more ground to cover (in terms of elevated inflation); This is a big caveat
· The level of uncertainty is completely elevated
· ECB provided indirect forward guidance in the 1st part of the statement
· The ECB projection cutoff date was February 15th
· It is impossible to predict the rate path amid so much uncertainty
· The level of uncertainty is completely elevate
· The banking sector is currently in a much better position than it was in 2008
· Today 3-4 GC members didn’t support the decision; Dissenters wanted more time
· ECB will be data-dependent for future rate action
· A very Large Majority Supported the ECB decision today
· No conflict/tradeoff between price & financial stability goals
· We stand ready to give new facilities if needed to ensure financial stability; COVID-era liquidity tools are now still available if needed
· ECB has sufficient tools to ensure financial stability
· In terms of underlying core inflation, I’m not seeing much improvement
· Core inflation has improved slightly, but not significantly
· We are starting to see policy transmission via the credit channel
· It has not yet been determined whether TPI is required, but it may be at some point
· We have not made any decision on the APP roll-off
· Sees no 2008 GFC types of event mow as banks are now much strong
· ECB will be data dependent
· Monetary policy appears to have been transmitted quickly
· ECB is monitoring recent banking events, and financial markets and is ready to respond with appropriate tools
· EU banking supervision and regulatory capital requirement (BASEL-III) are more robust than the U.S.
· Overall, it’s not the usual situation
· ECB didn’t discuss the pace of QT
ECB’s de Guindos (VP):
· Banks are resilient, and capital is higher than it was previously
· Liquidity positions are strong and liquidity buffers are high quality
· Higher rates are positive for the margins (NIM) of banks
· The U.S. SVB bank crisis is unique
Customary ECB source-based leaks after the official ECB meeting/presser:
· The ECB’s policy toolkit is fully equipped to provide liquidity support to the euro area financial system if needed
· The governing council is closely monitoring current market tensions and is prepared to respond as needed
· The ECB refrains from signaling future rate moves in a statement
· The banking sector is resilient
· ECB staff expect growth to pick up further, to 1.6%, in both 2024 and 2025, underpinned by a robust labor market, improving confidence and a recovery in real income
· We are prepared to act if necessary
· ECB: policy rate decisions will be determined by its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission
· If necessary, the ECB’s policy toolkit is fully equipped to provide liquidity support to the Eurozone financial system
· ECB Policymakers agreed to go ahead with a 50 bps hike after the SNB threw a lifeline to Credit Suisse
· The ECB’s policy debate was between a 50-bps hike or keeping rates unchanged; there was no mention of a 25-bps hike
· The ECB feared that ditching the half-point hike might panic investors (credibility issues)
· According to the people, several hawkish officials still see the terminal rate well above the current 3%, citing President Christine Lagarde’s remark that the ECB “would have more ground to cover” if its baseline economic forecast is confirmed
· However, some are wondering if the peak in borrowing costs is now lower than previously thought
· Fears that anything but a half-point hike would trigger panic among investors helped settle the European Central Bank’s interest-rate decision on Thursday
· Traders were scouring financial markets for signs that other lenders might face the same strains that had hammered Credit Suisse Group AG and Silicon Valley Bank as ECB officials met over the past two days
· Earlier this week, ECB Vice President Luis de Guindos warned European finance ministers that banks could be vulnerable to rising borrowing costs
On Thursday, EURUSD slips even before the ECB decision after a report that ECB officials are concerned about the growing banking crisis in Europe and U.S. The market was discounting just 30% odd of a +50 bps ECB hike vs 60% earlier just before the ECB decision Thursday.
On Tuesday, ECB’s VP de Guindos told various EU member state finance ministers:
· There is no room for complacency in the EU banking system
· Confidence drop may cause EU contagion
· Some EU banks could be vulnerable
Conclusions:
Eurozone core inflation is now around +5.60%. ECB/Lagarde is now seeing elevated/higher core inflation for longer, while employment is a robust and overall economic activity better than previously expected. Thus core CPI is still substantially above ECB’s +2% target, while overall economic growth is still in the expansion stage, paving the way for more rate cuts in the coming months into an appropriate restrictive zone, so that core CPI falls to at least +4.6% in 2023, +2.5% in 2024 and +2.2% by Dec’25.
As per Taylor’s rule, for the Eurozone:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(4.50-2.00) =0+2+2.5=4.5%
Here for EU /ECB
A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=4.5%
As per Taylor’s rule, for the US:
Recommended policy rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.5-2.00) =0+2+3.5=5.5%
Here for U.S. /Fed
A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=5.5%
Looking ahead, ECB may further hike by +50 bps in May and +25 bps in June for a terminal rate (MLF/Repo rate) of +4.50% and benchmark deposit rate (reverse repo) of +3.75%. ECB will sit tight around the +4.50% terminal rate for at least Dec’24, until the average core CPI falls below +3.00%. Fed may also go for calibrated +25 bps rate hikes each on 22nd March, 3rd May, and 14th June for a terminal rate of +5.50% and then pause. Both Fed and ECB have to ensure price stability, financial stability, and also their credibility. As monetary/fiscal authority on both sides of the Atlantic will not allow any banks to fall, both Fed and ECB may continue their rate hike plans.
In the U.S., a consortium of 11 big banks will rescue FRB (First Republic Bank) by infusing $30B. The Treasury Department, the Federal Reserve, the FDIC, and the OCC confirmed the decision describing the move as a sign of the sector’s resiliency in the country.
Wells Fargo, Citigroup, JPMorgan Chase, and Bank of America will each contribute $5 billion. Meanwhile, Morgan Stanley and Goldman Sachs will do it for $2.5 billion. PNC, US Bancorp, Truist, State Street, and Bank of New York Mellon will deposit around $1 billion each. These banks said in a joint statement: “America’s financial system is among the best in the world, and America’s banks – large, midsize, and community banks – do an extraordinary job serving the banking needs of their unique customers and communities. The banking system has strong credit, plenty of liquidity, strong capital, and strong profitability. Recent events did nothing to change this”.
The US Treasury Secretary Yellen, Fed’s Powell, and FDIC said:
· This demonstrates the resilience of the banking system
· We stand ready to provide liquidity to eligible institutions
· First Republic deposits show resilience
The model of big U.S. banks rescuing regional/small banks along with active support of the central bank/government is like India’s example of the Yes Bank bailout, which will be eventually followed in Europe too directly/indirectly. The Swiss government/SNB may also request/force UBS to merge/buy out Credit Suisse, resulting in further consolidation of the banking sector in Europe/EU.
Bottom line:
As the immediate concern of financial stability eases, both Fed and ECB may go for their planned rate hikes in a calibrated manner to ensure price stability. Although Fed is providing liquidity support to some regional banks directly and expanding its balance sheet (back door QE), this is a temporary emergency measure for the sake of Financial stability and thus may continue to hike rates for price stability. As per Fed’s latest data, its B/S expanded by almost $300B in one week (to bail out regional banks), which is equivalent to 4-months of QT or almost 50% of the total QT done so far; i.e. Fed will ensure Financial Stability at any cost, but also have to ensure Price stability by further calibrated hiking. The same is also true for ECB.
Source: iforex.in
