‘Terminal rate’ in ECB column looks too high: Mike Dolan By Reuters

By Mike Dolan

LONDON (Reuters) – The market’s best guess is that the European Central Bank will not step on the accelerator in the cycle ahead – which is either far from light or extremely worrying.

Based on current money market forecasts, the ECB’s global rate setting is expected to continue to act as at least a mild brake on the slow-growing bloc over the next two years, even as it gradually cuts its main policy rate.

Avoiding overshooting the 2% inflation target and maintaining positive growth without switching to a stimulative stance seems a difficult task given the deep problems facing the region for more than a decade.

The ECB has already pulled ahead of the Federal Reserve and is likely to cut its key interest rate for the second time this cycle before the Fed actually kicks in later this month.

That makes intuitive sense. The eurozone economy has been much weaker than its US counterpart over the past two years.

And Europe is much more vulnerable to China’s worrying economic funk and the global manufacturing downturn, given that manufacturing accounts for 20% of the German economy and 15% of the wider eurozone.

Disinflation – particularly in commodity prices – has been rapid and the ECB’s inflation targets are on target.

But the dilemma is less about why ECB easing is already underway than where it is expected to end up.

Money markets currently see the ECB’s policy rates falling minimally over the next 12 to 18 months to around 2.10%-2.20%.

But assuming, as the ECB does, that inflation will fall sustainably to its 2.0% target before 2026, then markets suggest that the ECB’s “real” rates will remain in positive territory throughout the cycle.

This means rates would remain above where most ECB policymakers assume the legendary neutral “R-star” rate is currently.

Furthermore, while the market assumes that ECB rates will ultimately remain more than 125 basis points (bps) below Fed equivalents, current prices also suggest that the Fed will cut 50 bps more than the ECB on the entire cycle until the end of next year.

Some of the market’s caution has been guided by ECB officials, of course, many of whom are adamant that they still need to reduce high service-sector inflation and rapid wage growth.

By reaffirming their resolve to keep policy somewhat tight regardless of the growth implications, officials could also be playing a psychological game to keep inflationary expectations low.

Last week, Isabel Schnabel, a member of the ECB’s governing board, stressed the importance of “perseverance” in policy and the “perceived commitment” of central banks to meet their targets, as needed, for price stability to be restored after a shock.

And intriguingly, she suggested that the uncertainty surrounding the neutral rate could make determining the terminal rate a bit of a guesswork.

“The closer policy rates get to the upper band of neutral interest rate estimates — that is, the less certain we are about how restrictive our policy is — the more cautious we should be,” Schnabel said in a speech in Tallinn.

UNDERSTOCK OR STOCK?

All this might go some way to explaining why the ECB is reluctant to sound the “all clear”, but not why the market seems so tempted to bet on a resurgence of monetary stimulus.

If key structural aspects of the eurozone economy have not changed radically since the pandemic, then the ECB will likely need to act aggressively to re-stimulate the slow-growing region.

For starters, the significant slowdown in global manufacturing and Europe’s still growing direct trade links with a struggling Chinese economy suggest that the eurozone faces the real risk of both negative growth and even deflation in the year ahead.

For example, Barclays recently pointed out that annual eurozone core inflation fell to just 0.4% in July as headline inflation in the region retreated to 2.2%.

Meanwhile, China’s annual factory goods price deflation remains significant.

Hedge fund manager Stephen Jen has long warned that Western countries could significantly exceed inflation expectations and slide into outright deflation as supply gaps responsible for most of the recent inflationary shock narrow . And he reaffirmed that belief last week.

“It’s likely to be a period of total deflation, I still think,” he said.

If this constellation plays out, then how can the market not price in a high probability that the ECB will have to dramatically change its monetary policy stance going forward?

Note that before October 2023, the ECB’s “real” policy rates spent all but one month of the previous decade in negative territory.

Has it changed that much since the pandemic? True, geopolitical upheavals have changed the playing field and access to cheap Russian gas has disappeared.

But far more important influences on the region’s economic potential are much the same as at the end of 2019, not least the aging demographic profile of the euro bloc, which contrasts sharply with the brighter image of the United States.

Of course, the reason why the ECB is not expected to move to a truly stimulative policy stance over the cycle is that it may not succeed.

Deutsche Bank’s credit team recently highlighted surveys showing employment across the bloc deteriorating, even as core wages and price increases still remain too high for many central bank officials.

“Sticky inflation could introduce more noise into the ECB’s reaction function, biasing the ECB too much relative to European growth trends,” Steve Caprio and the Deutsche team wrote last month.

But when trying to find the signal through all this noise, it seems that undershooting inflation expectations should be the biggest concern for the ECB and the markets.

The opinions expressed here are those of the author, columnist at Reuters

(By Mike Dolan; Editing by Jamie Freed)