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Intesa Sanpaolo: ECB moves to quench flaring expectations

Intesa Sanpaolo: The European Central Bank’s monetary policy meeting of 28 October will be merely  interlocutory, an intermediate stop on the way towards the important decisions that will have to be made and communicated on 16 December.

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By Luca Mezzomo  Economist

Although no important announcement will be made next week, the ECB will take this  opportunity to reassert its stance on policy rates and cool expectations for a hike that  have recently emerged in money market curves. Over the past few days, several  members of the Governing Council have already spoken out to stress the fact that  such expectations are at odds with the decision-making rule introduced following the
strategy review.

For what concerns the December decisions, we confirm our expectations for an announcement PEPP net purchases will be discontinued as of 31 March 2022,  combined with some changes to APP management, possibly stepped up by means of  a temporary envelope, and a new TLTRO programme designed as a safeguard tool.

On occasion of the press conference of 9 September, President Lagarde clearly indicated the  16 December meeting as the one at which the European Central Bank will make crucial  decisions on the PEPP, on TLTROs, and on a potential recalibration of other tools to smooth the  exit from the PEPP. Therefore, the monetary policy meeting to be held on 28 October is  prospected as being entirely interlocutory.

The wording of the monetary policy decision communication should be the same as in  September, including the section on “moderately” smaller net purchases under the PEPP than in  2Q and 3Q 2021. The trend of the real economy remains consistent with the staff’s forecasts;  inflation was again higher than expected, although the prospect of a decline in 2022 is still  motivated. Financing conditions remain favourable, considering that the rise of nominal rates  has not filtered through to real rates, that sovereign spreads are stable, and that the exchange  rate has weakened. Market inflation expectations, undoubtedly on the rise over the past few  weeks, are roughly consistent with the ECB’s target.

The press conference should confirm and strengthen the acknowledgement that upside risks  exist to the staff’s inflation forecasts, as opposed to balanced risks on growth. At the same time,  however, President Lagarde may use the press conference to reassert that expectations for a  policy rate hike at the end of 2022 are at odds with the guidance on rates contained in the  monetary policy decision .

The ECB could use the meeting to better define the exit strategy, by laying out the priorities in  the preparatory work needed to be done by the staff ahead of the mid-December meeting.  Over the past few weeks, news agencies have reported rumours (not always consistent) on  how the APP could be revised, presumably referred to one or more options the Council  intended to consider, and on which further exploratory work was requested. For what concerns  the strategy to exit the PEPP, see the last section. Lagarde will probably opt not to make  commitments on the final outcome of the process, although she may provide more detailed  indications on the elements that could be included in the recalibration. The need to  communicate with the markets would become more urgent should the ECB lean towards a  more restrictive mix of measures than expected by market consensus, of which the ECB is  aware thanks to its Survey of Monetary Analysts.

Verbal action under way to quench premature expectations for rate hikes  In October, rates as implied by 3-month Euribor futures with December 2022 maturity increased  by 9bps, placing the rise compared to current levels at 20bps. OISs are pricing in higher rates by  13bps by the end of 2022. In our Weekly Economic Monitor of Friday 15 October, we expressed  the view that a rate hike at the end of 2022 would be incompatible with the ECB’s guidance on  policy rates, given both the difficulty in respecting the retrospective principle on underlying  inflation by next June, and because this would imply closing the APP at only a few months  distance from the unwinding of the PEPP. Furthermore, we believe the markets are currently  underestimating the relevance of the ECB’s change in course following its recent strategy  review.

Over the past few days, the ECB has also started to act to counter the market’s movement:

– In an interview with Bloomberg, on Monday 18 October the Governor of the Bank of Italy,  Ignazio Visco, said that market expectations on rates “are not that much in line” with the  ECB’s stance1.

– Philip Lane, member of the Executive Committee, said on 19 October that market  expectations are not consistent with the guidance offered by the ECB on policy rates2;

– On 19 October, the Governor of the Banque de France, Villeroy de Galhau, said that there  is no reason for the ECB to hike rates next year, and also reasserted his view that inflation will  drop back below 2% in 20223.

During the press conference of 28 October, we expect Christine Lagarde to be asked to  comment on the expectations for a rate hike at the end of 2022 that the markets still seem to  be pricing in. The ECB president will once again reassert that, based on the staff’s forecasts,  inflation could dip back down below 2% in 2022, and that underlying inflation will stay too low.  The president could also reassert that rate hike at the end of 2022 would not be consistent with  forward guidance. We currently believe rates could be raised starting from 2023H2.  Decisions to be made on 16 December: what we know and needs to be  discussed  For what concerns the decisions to be taken on 16 December, the members of the Governing

Council have been very cautious in making statements on the mix of actions they consider  most appropriate. The ending of the PEPP on 31 March 2022 seems certain: the pandemic crisis  seems to have been overcome, and surveys show this scenario has already been embraced by  the market consensus. Some statements seemed to indicate that the APP could be made  little more flexible, for instance by setting goals in terms of net purchases over longer periods,  rather than monthly, to better compensate for the impact of seasonal effects on issuance and  temporary shifts in market sentiment. However, some Council members have been steadfast in  rejecting the possibility of the APP being made as flexible as the PEPP. Several governors  mentioned the possibility of the supranational debt limits under the PSPP being raised.

Uncertainty is greater on the ECB reaching an agreement to temporarily increase the volume of  net purchases under the APP. Equally uncertain is the possibility of the ECB renewing the TLTRO  programme, although an agreement could be reached on launching a “guarantee” LTRO  programme stripped of the incentives offered by TLTRO III.

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