ECB may need 75 bps rates hikes in Oct, Dec before balance sheet cut

The European Central Bank should raise interest rates by 75 basis points at both of its upcoming meetings this year, then needs to discuss shrinking its balance sheet in 2023 as inflation is far too high, ECB policymaker Bostjan Vasle said.

Moving slowly initially then picking up pace in recent months, the ECB has been unwinding policy support all year and lifted rates by a combined 125 basis points at its past two meetings, the fastest pace of policy tightening on record.

Its 0.75% deposit rate is still low enough to stimulate growth, however, and needs to be jacked up to levels where it starts putting the brake on the economy, Vasle, Slovenia’s central bank chief, told Reuters in an interview on the sidelines of the International Monetary Fund and World Bank annual meetings.

“Given both headline and core inflation dynamics, I think we will continue with interest rates increases at our next two meetings,” he said. “I think that our most recent pace for hikes is also appropriate at our next two meetings.”

When asked if he meant 75 basis points, Vasle, considered a hawk on the 25-member Governing Council, said “I think so.”

The core of the problem is that inflation is now running at 10%, five times the ECB’s target, and will stay above 2% through 2024, raising the risk it gets entrenched at a higher level.

ECB policymakers have said that the first goal is to reach the “neutral” level for rates, where the bank is neither stimulating nor holding back growth.

This is seen somewhere between 1.5% and 2% but Vasle said that alone will not be enough to tame inflation, even if the bloc were to suffer a recession this winter.

“I’m of the opinion that we will have to go above the neutral level in order to calm inflation pressures, which are currently in the pipeline,” Vasle said.

Once the neutral rate is hit around the turn of the year, the ECB should also start discussing how to reduce its close to 9 trillion euro ($8.76 trillion) balance sheet after the bank bought nearly 5 trillion euros worth of public and private bonds.

While it does not add more bonds to its portfolio, cash from maturing debt is still being reinvested back into the market, including in the 3.3 trillion euro Asset Purchase Programme.

“After reaching the neutral level, I think it would be an appropriate time to start discussing options for the reversal of the Asset Purchase Programme,” Vasle said.

Such reversal is often referred to as “quantitative tightening”, or QT.

“Most probably 2023 will be the appropriate time for discussion and decisions regarding the APP.”

However, reivnvestments in a smaller Pandemic Emergency Purchase Programme, set to run through 2024, should continue as planned, Vasle added.

While an inflation peak may be close if there are no additional shocks from Russia’s invasion of Ukraine, the retreat will be quite slow initially, Vasle said.

“At the moment inflation expectations are still well anchored but there are serious risks that this will not remain the case if we do not react decisively,” Vasle said.

($1 = 1.0274 euros)