The ECB Is Moving Closer to Concluding Its Stimulus Programme Due to the Risk of Inflation

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As Russia’s invasion of Ukraine threatens to push prices even higher, the European Central Bank surprisingly expedited the winding down of monetary assistance, signaling that it is more concerned about record inflation than sluggish economic growth.

The ECB committed to limit bond purchases starting in May and warned the program may be ended as early as the third quarter, calling the war a “watershed” moment for Europe. They attempted to mitigate this by making a subsequent rate hike less automatic.

President Christine Lagarde, who wore a patch with the colors of the Ukrainian flag on her jacket, told reporters in Frankfurt that “the Governing Council regards it as increasingly likely that inflation would stabilize around its 2% objective over the medium term.” “The conflict in Ukraine poses a significant upside risk, particularly for energy prices.”

Economists had predicted a delay in significant policy choices to enable time to examine the consequences of Russia’s attack, but the outcome exceeded expectations. Plans to stop large-scale asset purchases and implement negative interest rates, according to some Governing Council members, would likely be postponed.

The euro slipped 0.7 percent to $US1.0996 on the day. Italian bonds fell in value, with the 10-year bond yield rising 24 basis points to 1.915 percent.

Investors interpreted the faster withdrawal of asset purchases as a sign that rate hikes are on the way, with money markets now forecasting a quarter-point increase in October, up from a quarter-point increase in December. In the first half of 2023, they expect two additional raises, bringing the key rate to 0.25 percent.

While the Governing Council no longer believes interest rates will go “lower” than they are today, it does say that any increases will be “gradual” and occur “sometime after” bond purchases finish rather than “shortly.”

“Clearly,’ some time after’ encompasses everything,” Lagarde remarked. “It may be the next week, or it could be months later.” By doing so, I believe we’re implying that the time horizon isn’t the most important factor. The statistics will be used to back up the judgment.”

Even if the ECB raises rates this year, it will lag behind several of its biggest counterparts in combating inflation. The Bank of Canada hiked interest rates last week and expects its balance sheet to shrink fast once its bond holdings are sold off.

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Liftoff is all but guaranteed at the Federal Reserve next week when the Bank of England is generally expected to raise borrowing prices for the third time in a row.

Since Russia’s incursion two weeks ago, Lagarde and her colleagues have been scrambling to assess how adversely sanctions, trade disruptions, and, most importantly, rising energy costs will affect the 19-nation union.

Balancing act described as “very difficult”

What is clear is that the Kremlin’s onslaught, as well as the ensuing rise in oil and natural gas contracts, will push inflation higher than the current 5.8% high. This makes it more difficult to offer assistance while keeping prices from spiraling out of control.

“The ECB’s balancing act is incredibly difficult,” said Paul Craig, portfolio manager at Quilter Investors, in a statement. In the face of an inflationary shock that necessitates “rapid and decisive action,” as well as the possibility of recession from Russia’s invasion, the “ECB has chosen the route of least resistance.”

Because of the rise in energy prices, the ECB revised its inflation projection for this year, raising it to 5.1 percent from 3.2 percent. According to Lagarde, the average for 2024 will be 1.9 percent, which is barely below the ECB’s aim.

While the ECB lowered its growth projection for this year and next, it still predicted solid growth. On the other hand, Goldman Sachs projected on Thursday that economic output will contract in the second quarter, with inflation likely to rise to 8%. Former ECB official Otmar Issing has warned that a rerun of the 1970s stagflation is the currency bloc’s “greatest concern.”

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The ECB will begin to taper its stimulus in May, when it will reduce bond purchases to €30 billion ($45 billion), followed by €20 billion in June.

“We’re not talking about speeding up, tightening up, we’re talking about normalizing,” Lagarde added, referring to the rate of debt purchases. “The support that net asset purchases can provide to policy rates is nearing an end, necessitating a reduction in the pace of purchases.”

At Thursday’s decision, policymakers differed on what to do, according to Lagarde.

“Some members suggested that, given the uncertainty we face, we should be uncertain ourselves and do nothing,” she stated.

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