The European Central Bank (ECB) raised its interest rate by another 75 basis points (bps) to 1.5% at the October meeting, bringing its policy rate now within the band of most estimates for a neutral configuration for the euro area, namely 1.25% to 2.0%.
With an expected 50-bp rise to follow in December, we believe the ECB will likely transition towards moving in more conventional 25-bp increments next year, as the hiking cycle pivots from policy normalisation to policy tightening and with inflationary pressures expected to gradually subside.
A peak policy rate of 2.7% now priced in by the market looks reasonable given current information, the large uncertainty around inflation dynamics, and relative to other major developed market jurisdictions such as the U.K. or U.S.
Any measure taken by the ECB to better control money market rates and preserve the monetary policy transmission mechanism will likely result in easing core government bond richness, and help restore a more balanced relationship between European interest rate swaps and core government bond market pricing.
Quantitative tightening will come into sharper relief towards the end of the year. This will require careful calibration, as the ECB will want to avoid a situation such as that recently experienced in the U.K., where the Bank of England intended to reduce bond holdings for monetary policy purposes but acquired bonds on financial stability grounds instead.
What about interest rates?
ECB President Christine Lagarde reiterated at the press conference following the meeting that there are more rate hikes to come, and that the ECB currently doesn’t have a strong view about the end point of the interest rate journey. It remains firmly in meeting-by-meeting mode.