ECB minutes show tentatively growing recession concerns

The just-released minutes of the ECB’s October meeting underline the ECB’s determination to continue hiking interest rates, while at the same time coping with high uncertainty and growing concerns about the severity of the looming recession.

Here are the main takeaways from the minutes:

• Shallow recession not enough to bring down inflation. There was a discussion on the potential severity of a looming recession, with a common view that a shallow recession would not be enough to bring down inflation. The ECB discussed possible channels through which a shallow recession could become a deeper and longer recession. Interestingly, and despite earlier credit crunches, the ECB did not see the banking sector as a potential channel but rather the housing market and eventually the labour market. “It was argued that, in the event of a shallow recession, the Governing Council should continue normalising and tightening monetary policy, whereas it might want to pause if there was a prolonged and deep recession, which would be likely to curb inflation to a larger extent.”
• Fiscal policy. The ECB’s view on fiscal stimulus and its impact on the economy was a bit ambiguous, seeing “a risk that fiscal compensation packages would turn out to be bigger than warranted”.
• Longer-term inflation. Remarkably, there was a common view that most measures of longer-term inflation expectations stood at around 2%. Remarkable as this would take away the necessity to move monetary policy into restrictive territory.
• Debate on neutral level of policy rate. It remains unclear what the ECB has in mind as a neutral level for interest rates. In some paragraphs, it is said that a “neutral level” should be reached swiftly, while in other paragraphs, the entire concept of a neutral or terminal interest rate is debunked.
• On the size of the rate hike. Some ECB members argued in favour of a 50bp rate hike but the large majority favoured the 75bp option.
• Tail wagging the dog? One argument to go for a 75bp rate hike was the fact that financial market participants had also priced in such a hike. “It was argued that falling short of these market expectations would imply an unwelcome loosening impulse, potentially undermining confidence in the Governing Council’s commitment to price stability.”
• Nothing on pivot. At least according to the minutes, there hadn’t been a discussion on potentially slowing down the pace of rate hikes or starting quantitative easing.

All in all, there were only some signs between the lines that the ECB could slow down the pace of rate hikes at the December meeting.

While the October decision was very uncontroversial and supported by a large majority, recent comments by ECB officials suggest that the discussion at the December meeting will be much more heated and controversial. In fact, the voices of the doves have again become louder, while the hawks seem to be prepared to slow down the pace of rate hikes. Data releases and the forecasts presented at the December meeting will have something for both: a further increase in headline inflation and no further weakening of the economy but also very likely inflation coming down significantly in 2024 and 2025.

As a consequence, we currently expect the ECB to hike rates by 50bp in December and by another 25bp in February. The big question and probably also the big bargain between doves and hawks will be around quantitative tightening (QT) or in other words, the shrinking of the ECB’s balance sheet. Earlier and more significant QT could be the bargaining chip for an end to rate hikes. We expect the ECB to announce a gradual reduction of the reinvestments of its bond holdings under the Asset Purchase Programme (APP) at the December meeting, with the aim to stop the reinvestments by end-2023.

The minutes of the ECB's October meeting have some tentative signs that concerns of a more severe recession are growing, at least with some ECB members. This note of caution combined with long-term inflation expectations that are still close to 2% could allow the ECB to at least move towards a pause in its rate hike cycle soon.