Five questions for the ECB

By Dhara Ranasinghe, Stefano Rebaudo and Kripa Jayaram

LONDON (Reuters) – The European Central Bank meets on Thursday and appears in no mood to slow the pace of aggressive interest rate hikes in the face of runaway inflation, even as the economic outlook darkens.

It has raised rates by a total of 125 basis points (bps) since July, the fastest pace of policy tightening on record.

Recession risks are unlikely to hold back just yet, but markets are looking for signs that a pause may be coming.

“The central bank has few options other than offering another huge rate hike and sounding hawkish,” said Nordea chief analyst Jan von Gerich.

Here are five key questions on the market radar.

1/ What will the ECB do this week?

Economists polled by Reuters expect rates to rise 75 basis points to 1.5%, a view reflected in market prices. Policymakers argued for a steep rate hike, with most specifying a preference for 75 basis points.

The ECB could announce a possible change to the rules governing cheap long-term loans, targeted long-term refinancing operations (TLTROs).

Investors will also be looking to ECB boss Christine Lagarde for advice on how the ECB views the trade-off between recession risks and inflation, and when it might suspend tightening.

“It makes sense to expect a 75 basis point rate hike, signals that the ECB will shrink its balance sheet and a change in TLTRO rules to reduce excess liquidity,” said Francis Yared, Global Head of Rates Research at Deutsche Bank. “What’s not clear is how much of this the ECB will announce (this week).”

(ECB set for another oversized rate hike https://graphics.Reuters.com/GLOBAL-MARKETS/myvmomnnovr/chart.png)

2/ Is there an indication that inflation is peaking?

Economists say it’s too early to call a spike in inflation, but the odds of it coming soon are increasing. Inflation accelerated to nearly 10%, a level not seen in some eurozone countries for more than 70 years.

One reason for optimism is that gas prices in Europe are down 65% from the peak in August.

While an inflation peak could be near if there are no additional shocks from the war in Ukraine, the decline will be slow at first, said ECB policy chief Bostjan Vasle.

Another problem is that inflation is widespread, so even when headline numbers fall, underlying price growth will remain uncomfortably high.

The spike in inflation is crucial to whether policymakers will need to push rates past the neutral setting – where they neither boost nor slow growth – a rate usually pegged at between 1.5% and 2% but which some policymakers politicians deem it too low.

(Is Eurozone inflation peaking? https://graphics.Reuters.com/EUROZONE-MARKETS/dwpkdgrwmvm/chart.png)

3/ Are we about to get QT?

Not yet. But the ECB may change its language on reinvestments and provide more details in the coming months.

The next key political debate concerns how to reduce the more than 5 trillion euros of bonds on the ECB’s balance sheet in a process called quantitative tightening (QT).

Bundesbank President Joachim Nagel and Dutch central bank chief Klaas Knot said the moment for the QT, as part of a broader policy tightening, was approaching.

(The era of easy money is over The era of easy money is over https://graphics.Reuters.com/GLOBAL-MARKETS/byprjzaaxpe/chart.png)

4/ Is the ECB distributing liquidity to the banks and what will it do?

Eurozone banks are sitting on 2.1 trillion euros in cash distributed by the ECB at ultra-low, sometimes even negative, rates aimed at reviving the economy.

But rapid and large rate hikes mean banks can park that money at the ECB, earning a risk-free profit, angering policymakers who see it as manipulation of the system.

Policymakers are believed to be closing in on a deal to change rules governing bank lending, a move that would cut tens of billions of euros in potential bank profits. A decision could come Thursday.

(Who gets the ECB cash gift? Who gets the ECB cash gift? https://graphics.Reuters.com/EUROZONE-MARKETS/gdpzqryowvw/chart.png)

5/ To what extent is the ECB concerned about financial instability?

Aggressive rate hikes by major central banks and the rout in UK bonds raised concerns about financial instability.

The International Monetary Fund says risks to financial stability have increased “significantly” and Lagarde warned that markets could be overly optimistic about the economic outlook, raising the risk of a sharp market correction.

“The critical issue for the markets is financial stability,” said Flavio Carpenzano, head of fixed income investments at Capital Group, although he doesn’t expect the ECB to deal with it directly.

(Financial stability risk concerns rise Financial stability risk concerns rise https://graphics.Reuters.com/GLOBAL-MARKETS/zjpqjqkrzvx/chart.png)

(Reporting by Dhara Ranasinghe in London and Stefano Rebaudo in Milan; Graphics by Kripa Jayaram and Vincent Flasseur; Editing by Tommy Reggiori Wilkes and Andrea Ricci)

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