ECB preview: higher rates, tighter liquidity

The ECB is widely expected to hike policy rates by 75bp at its 27 October meeting and to commit to additional tightening in the next few months. We don’t expect much clarity on what it considers the ‘neutral rate’, but a growing consensus seems to be in favour of having the deposit rate at 2% by the end of the year (implying a further 50bp hike in December), with a reassessment of the economic and inflation outlook in early 2023.

A special focus of attention next week will turn to measures to limit the attractiveness of TLTROs. We expect the ECB to introduce a TLTRO-based tiering system to reduce the gains for banks benefitting from cheap TLTRO loans (the average rate on which is below the ECB’s deposit rate) and redepositing excess reserves at the ECB (at the deposit rate). This system will incentivise banks to repay the share of TLTRO not used for regular funding before June 2023. A broad-based reverse tiering system based on all banks’ excess reserves may create risks for the transmission of monetary policy to euro area money-market rates. Retroactive changes to TLTRO terms would raise legal risks and threaten the credibility of an instrument that could be needed again in the future.

The ECB will likely confirm that ‘quantitative tightening’ (QT) will start in 2023, once policy rates are normalised. Crucially, QT will be a gradual and passive process, starting with the end of reinvestments under the Asset Purchase Programme (APP) but not involving the active selling of bonds any time soon.

Meanwhile, the risk of a deeper-than-expected recession in the EU is rising despite additional fiscal support and the prospect of EU-wide measures to mitigate the energy shock. When the ECB staff updates its macroeconomic projections in December, we expect it to downgrade the growth outlook further and to show inflation returning to the ECB’s 2% target by 2025. This would be the decisive argument for the ECB to pause rate hikes in 2023.