Financial basis

The ECB will raise interest rates, which should reduce bank subsidies

By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) – The European Central Bank will raise interest rates again on Thursday and is likely to provide a key subsidy to commercial banks, taking another major step in tightening policy to tackle a historic spike in inflation.

Fearing that rapid price growth is taking root, the ECB has already hiked rates at the fastest pace on record, and there is little respite in sight as the unwinding of a decade of stimulus could extend into next year and beyond.

The ECB is almost certain to raise its deposit rate by 0.75% by 75 basis points – for a cumulative increase of 2 percentage points in three meetings – and to signal that it is not done yet, even if the The extent of subsequent movements remains open to debate.

But in a potentially bigger move, the bank is also expected to take the first steps in shrinking its 8.8 trillion-euro balance sheet, bloated by years of debt buying and ultra-cheap loans to banks.

“The ECB is still in catch-up mode,” BNP Paribas said. “We believe there is now a comfortable majority to bring rates into restrictive territory.”

But the rate decision will likely be the easy part of Thursday’s meeting.

Unlike September, no politician openly opposed the idea of ​​a 75 basis point hike on Thursday, and markets fully priced in such a move, suggesting easy unanimity, especially as the Reserve US federal government also hinted at a similar increase.

Signaling that future moves will be tougher, ECB President Christine Lagarde is likely to provide only vague guidance, saying more hikes are needed, but that incoming data and new December economic projections will be key.

Although inflation is high and underlying price growth is broadening, the overall picture could be more balanced than in the past as energy prices fall, a looming recession will ease price pressure and there is no sign of a wage-price spiral.

The ECB’s rate decision is scheduled for 13:15 GMT, followed by Lagarde’s press conference at 13:45 GMT.

BALANCE BATTLE

The real battle will likely be over how to shrink the ECB’s balance sheet.

The most pressing issue is some €2.1 trillion in ultra-cheap loans to commercial banks, which are now causing a political and financial headache.

After borrowing at zero or even negative rates, banks can now simply park that cash back at the ECB for a positive, risk-free return that increases with every rise in the deposit rate.

“The optics are poor in the context of a historic shock to household incomes, and the political pressure cannot be ignored,” said Pictet economist Frederik Ducrozet. “Note that some countries have implemented an exceptional tax on bank profits for similar reasons.”

The ECB would also be justified on monetary policy grounds to act, as the abundance of liquidity is keeping interest rates too low – money market rates are still slightly below the central bank deposit rate.

This essentially prevents rate hikes from being fully transmitted to the real economy, so the ECB is likely to decide to change the terms of these so-called targeted longer-term refinancing operations, or TLTROs, to encourage banks to repay them early.

The bank will probably decide to change the terms of the bank loan, but the devil will be in the details because only imperfect options are available to them.

The most controversial would be a simple change in terms, a decision that could be challenged in court.

“Changing the terms of the TLTRO could harm the credibility of the ECB and lead to banks’ reluctance to use TLTROs again in the future,” said ING economist Carsten Brzeski.

The ECB could also create a tiering system where reserves equal to TLTRO borrowing would be remunerated at lower rates, while it could also set a lower rate applied to excess reserves.

An even more contentious discussion for Thursday will focus on how to reduce the 5 trillion euros in debt, mostly government bonds, bought by the ECB.

While no decision is likely on that, policymakers will likely signal that they have begun to draw up plans to end a €3.3 trillion asset purchase program by not investing all of it. cash back in the maturing bond market.

(Reporting by Balazs Koranyi; Editing by Hugh Lawson)