17 December 2021 Monetary Policy & Inflation

2022 Grey Swan #14: ECB to Hike in 2022

How about that dovish staff forecast?

At the 16 December ECB meeting, the staff 2023-24 inflation projections are still below 2%. This makes my Grey Swan – the ECB hiking six months after the Fed – a shade darker. But I think this new information is insufficient to sink it completely.

The staff forecast is consistent with the modest wage gains we have seen this year, but may not be ‘forward looking’. The European labour market has closed the Covid gap well ahead of the US. And while wage negotiations take longer and wages are slower to adjust than in the US, UK, Canada, etc., Europe is much more unionised than the US. And if the expectations ball gets rolling, it can go a long way.

A removal of negative interest rates is not a rate lift-off in conventional policy terms.

I think neither markets nor policymakers currently differentiate between a removal of NIRP and a hiking cycle. And while the ECB has done much to justify using NIRP despite the critique of several monetary policy luminaries across the pond, clearly European banks and asset markets would be far happier if this unconventional episode is over sooner than later.

Yet I see a key hurdle to this step in the normalisation process. The debate on NIRP negative externalities and the arduous defence of NIRP on behalf of the ECB policy team has created an ownership bias to the tool. And the bias seems to be hindering a debate on whether it is necessary given the current macro environment.

Do we really need NIRP at this point in the cycle?

Risk takers who make decisions under uncertainty know identifying and correcting cognitive biases is essential to a rational and effective navigational process. If near-term inflation is high enough that the negative real rates are well below neutral while employment is at trend, NIRP stops being a monetary policy instrument and becomes either an FX manipulation tool or a tax on capital (an instrument for financial repression).

If it is the former, Europe will get much more inflation from the US via the currency channel next year. I doubt that either economically or politically we need inflation well above the ECB target, a form of flat tax that disproportionately hurts the lower-income percentiles. As for the latter, I think it would be unreasonable to keep an extra tax on capital while we have to launch a large-scale maturity transformation to upgrade the continent’s energy infrastructure.

While there are some long-term merits of giving NIRP conventional policy status, the near-term costs could be high.

If it is to relinquish the ownership bias, the ECB policy team should not be wrapping the removal of NIRP into the linear progression of a hiking cycle. By doing so, the ECB will remove the unconventional characteristic of the negative rate policy, thereby opening up the future distribution of policy rate expectations to the downside and allowing for more forward easing in future downturns. But importantly, the ECB will do so by penalising duration and raising the periphery funding costs by more than necessary. As such, it might be cleaner from the viewpoint of monetary policy theory and more conservative from the viewpoint of forward guidance and term premium impact to differentiate the removal of NIRP from the policy rate lift-off.

As such, my Grey Swan may end up a touch whiter than the headline would suggest: ‘ECB removal of NIRP, but still far from an above-zero hiking cycle.’