ECB: At the peak

In its latest meeting, the ECB Governing Council decided to tighten policy further, bringing the deposit rate to 4.00%. It considers that the current level of official rates, if maintained for a sufficiently long duration, will make a substantial contribution to bring inflation back to the 2% target in a timely way. Financial markets rallied, expressing a conviction that policy rates have reached their cyclical peak. The focus is now shifting to how long they will stay at this level and what will be the pace of easing thereafter. The ECB’s reaction function depends on the assessment of the inflation outlook in the light of the incoming economic and financial data, the dynamics of underlying inflation and the strength of monetary policy transmission. This leaves a lot of room for interpretation and market speculation. A clearer description of the reaction function would be helpful to avoid that interest rates and financial markets in general would become unduly volatile.

There’s a saying that a picture is worth a thousand words. Judging by the reaction of financial markets (charts 1-3) to the announcement of the ECB’s Governing Council decision on 14 September, something significant and market-friendly had happened, causing a drop in bond yields and the euro as well as an equity market rally.

Obviously, in the world of central banking, nuances matter so one needs the words to accompany the charts. Admittedly, policy rates were raised again -for the tenth time in a row-, bringing the deposit rate to 4.00% -an all-time high-, but the Governing Council now considers “that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target.”[1] This suggests that, based on the current data, policy is now sufficiently restrictive in the pursuit of the ECB’s inflation objective, which might imply that official rates will not have to be raised further in the near term. As time goes by, the impact of past rate hikes should become increasingly visible, which reduces the likelihood that after a pause, the ECB would hike again. In plain English, the announcement means that policy rates are at their peak, which explains the market reaction. Bond yields declined because the risk of further rate increases has dropped if not disappeared completely. The latter factor implies a slight reduction in the uncertainty surrounding the growth outlook, which triggered an equity rally through a decline in the required risk premium. Lower bond yields also helped of course. The euro weakened against the dollar because the Federal Reserve may continue to raise its official rates.

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