(Bloomberg) — One of the European Central Bank’s most senior officials said that investors risk underestimating the persistence of inflation, and the response needed to bring it under control.
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“We are still far away from claiming victory,” Executive Board member Isabel Schnabel said in an interview, citing the strength of underlying price pressures and faster wage increases. The economy’s reaction to interest-rate increases may prove weaker than in prior episodes, and if that transpires, “we may have to act more forcefully.”
The central bank has all but promised another half-point step in March, a hawkish stance that chimes with the US Federal Reserve’s own approach to continue steady hikes. Questioned if economists and investors are justified in assuming the ECB will halt tightening at a rate of 3.5%, Schnabel signaled that may be too optimistic.
“Markets are priced for perfection,” she said. “They assume inflation is going to come down very quickly toward 2% and it is going to stay there, while the economy will do just fine. That would be a very good outcome, but there is a risk that inflation proves to be more persistent than is currently priced by financial markets.”
While their short-term inflation measures have retrenched enormously from last year’s energy-induced spike, longer-term metrics remain elevated at about 2.4% — above the ECB’s 2% goal.
Money markets bolstered rate-hike bets after Schnabel’s remarks, pricing a 3.72% peak in the deposit rate by the end of the third quarter and almost removing all wagers on cuts in 2023.
Schnabel, who’s the ECB’s official in charge of markets and one of the more hawkish members of the Executive Board, suggested that policymakers are unlikely to judge the inflation outlook as satisfactory when releasing new projections in March.
A 50 basis-point hike next month is “necessary under virtually all plausible scenarios,” she said, insisting that “there is no inconsistency between our principle of data-dependency and these intentions because it’s very unlikely that the incoming data is going to put this intention into question.”
While headline inflation across the 20-nation euro zone has eased faster than expected along with energy costs, gauges that strip out volatile components are still clinging to record highs.
“A broad disinflation process has not even started,” Schnabel said.
Wages are therefore a concern. She cited forecasts for pay to rise as much as 5% in the coming years, too high compared with the ECB’s 2% inflation target.
“Wage growth has picked up substantially,” Schnabel said. “Given a longer duration of wage contracts compared to the US and a more centralized bargaining process, one could expect wage growth in the euro area to be more persistent.”
On Wednesday, President Christine Lagarde reiterated the ECB’s plan to keep rates at levels that cool the economy and guard against the risk of permanently higher inflation expectations.
Schnabel isn’t so sure that the current stance of borrowing costs is constraining growth yet.
“It is not so easy to judge whether our measures are already restrictive,” she said, arguing that the cost of money has only played a “very small role” so far in curbing banks’ appetite to lend.
She also said that shifts from variable to fixed-rate mortgages, shorter to longer bond maturities, a strong labor market and investments to advance the green transition mean that the economy may be less responsive to ECB policy.
Policymakers will have to stay the course “until we see robust evidence that inflation — and in particular underlying inflation — is going back to our target of 2% in a timely and durable manner,” Schnabel said. “It is highly unlikely that inflation pressures are going to vanish by themselves.”
Reducing its €5 trillion ($5.3 trillion) bond holdings will be part of the ECB’s efforts starting in March. Until June, an average of €15 billion a month will be rolled off the balance sheet in what’s commonly referred to as quantitative tightening.
While nothing is decided yet, “QT could be sped up after that,” Schnabel said. “We need to reduce the balance sheet and we want to do so in a measured and predictable way without causing any disturbances.”
The process will be driven mainly by technical considerations such as how much liquidity is needed to successfully steer money-market rates and also take into account how the ECB’s footprint impairs market functioning, she said.
With a strategy review under way through the end of the year on the future conduct of monetary policy, it’s too soon to say how far QT will proceed.
“We are still quite far away from the point where the size of our balance sheet may affect our ability to steer short-term interest rates,” Schnabel said. “This gives us a bit of time, but it is important, to at some point, to give an indication where we think the balance sheet is going to end up.”
–With assistance from James Hirai.
(Updates with market reaction in sixth paragraph.)
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