The inflation rate in the euro zone has reached a new record high. “Inflation has risen quickly, but it can also fall again very quickly,” says Pimco portfolio manager Konstantin Veit. Since the latest interest rate hike will only take effect with a time lag, it may take a little longer.
Now things have turned out even worse than feared: according to preliminary data, the inflation rate in the euro zone reached a record 10.7 percent in October. The expert estimate was already skeptical enough, which according to Bloomberg was 10.3 percent in advance. But inflation could be slowly reaching its peak. “In the final quarter of this year, we are likely to experience the peak of inflation in the euro zone,” says Konstantin Veit in the Capital interview, portfolio manager at asset manager Pimco in London. “Inflation has risen quickly, but it can also fall again very quickly.”
But it may take a while until then, also because the most recent interest rate hikes by the European Central Bank by a total of 200 basis points will only take effect with a time lag. “We will probably not see the full effect of the interest rate hikes until the middle of next year,” is Veit’s forecast. During her recent press conference, ECB President Christine Lagarde highlighted those time lags whose existence has been standard in economic theory for decades. The ECB raised its key interest rate by 75 basis points for the second time last Thursday, and will then return to 50 basis points in December according to Veit’s estimates. “The closer the ECB gets to neutral interest rates, the more cautious it will be,” is his forecast.
The neutral interest rate is a level at which monetary policy has neither an expansionary nor a contractionary effect on the economy. The problem: this neutral interest rate is not a fixed value, but has to be estimated. The estimates for the euro zone lie in a very wide range of 1.25 to 2.0 percent. The key interest rate currently relevant for the market, the deposit rate, is 1.50 percent from this Wednesday after the announcement last week. At the latest with 50 basis points in December, the ECB would definitely have arrived at the upper end of the neutral interest rate, it may even be there now.
“From two percent, the ECB will probably become more cautious when it comes to interest rate hikes,” says Veit. Then the usual rate hikes of 25 basis points could come into play again. “A period of calm is then also conceivable,” stresses Veit, ie a pause in interest rate hikes. In principle, the central bank will not be deterred from raising interest rates as long as the expected recession turns out to be mild, i.e. the economy in the euro zone should only shrink by around 1 percent. “A mild recession will probably not solve all inflation problems,” stresses Veit. The market is currently pricing in a target interest rate of 3 percent, but Veit does not want to commit himself specifically. “Uncertainty about inflation is very high and interest rate developments are very dependent on how inflation develops in the coming months,” he says. However, the ECB has also regained some credibility with its jumbo rate hikes. “The ECB has recently shown that it is serious about fighting inflation.”
But even if the ECB slows down the pace of interest rate hikes from December, it is likely to tighten monetary policy further. According to Veit, the fact that the long-term financing transactions of the ECB, the TLTROs, will automatically expire in 2024 will contribute to this. Their volume could even drop earlier because the ECB announced last week that it would tighten the conditions for the TLTROs. According to Veit, these tenders, or to put it simply: emissions, contain around 2.1 trillion euros of the ECB’s current balance sheet of 8.8 trillion euros. Another starting point for a tighter monetary policy is quantitative tightening (QT), i.e. the reversal of bond purchases from the quantitative easing programs (quantitative easing, QE). Veit expects concrete statements from the ECB in December on how this should work.
“We assume that it will only deal with its regular APP purchase program and not with the PEPP pandemic program. It will remain the first line of defense in the fight against fragmentation,” says Veit. In addition, according to his assessment, the ECB will initially only act passively, i.e. no longer reinvest returns from expiring bonds, as has been the case up to now. “Right now I don’t expect the ECB to actively sell bonds on the market.” But the passive approach would also have a significant impact on the financial market, because according to Veit’s estimates, around 250 billion euros would disappear from the ECB’s balance sheet every year.
