Euro zone to end negative interest rates within months, Lagarde indicates

Euro hit its highest level for a month against dollar

Christine Lagarde has signalled for the first time that the European Central Bank's (ECB) eight-year experiment with negative rates will end within months, saying borrowing costs are on track to hit zero by the end of September.

The ECB president wrote in a blog on Monday that, “based on the current outlook”, the institution was “likely to be in a position to exit negative interest rates by the end of the third quarter”. The deposit rate is now minus 0.5 per cent and has been in negative territory since 2014, when the region was facing a sovereign debt crisis.

The euro hit its highest level for a month against the dollar, partially offsetting concerns among officials that a weaker single currency would exacerbate price pressures. Borrowing costs for euro zone governments rose on the back of the remarks.

Policy

The ECB president is under pressure to accelerate the withdrawal of its ultra-loose monetary policy to tackle record euro zone inflation. Most analysts now expect the bank to raise rates by at least 0.25 percentage points at its July meeting a few weeks after it stops buying more bonds.

Ms Lagarde wrote: “If we see inflation stabilising at 2 per cent over the medium term, a progressive further normalisation of interest rates towards the neutral rate will be appropriate.”

The neutral level of rates is the optimal level where an economy is neither overheating nor being held back. ECB officials estimate the neutral rate for the euro zone at between 1 per cent and 2 per cent, but economists are divided on whether it will raise rates above that level to constrict demand in an effort to tame inflation.

Ms Lagarde said rates could rise above the neutral rate “if the euro area were overheating”. But with the euro zone facing “negative supply shocks” from the war in Ukraine, supply chain bottlenecks and Chinese coronavirus lockdowns, there were “arguments for gradualism, optionality and flexibility when adjusting monetary policy”.

Ms Lagarde’s comments sent the euro up 1.1 per cent against the dollar to $1.0684. The euro has fallen more than 12 per cent against the dollar in the past year. Highlighting the impact of the weaker currency, Ms Lagarde said higher import prices had cost the euro zone €170 billion, or 1.3 per cent of gross domestic product, in the year to March.

Germany’s 10-year bond yield rose 0.05 percentage points to 0.99 per cent. Bond yields rise when their prices fall.

Sentiment

Frederik Ducrozet, a strategist at Pictet Wealth Management, said the market reaction "looks counterintuitive", adding that "Ms Lagarde's comments on flexibility suggest no rush to tighten policy beyond neutral".

Investors were also encouraged by an unexpected brightening of German business sentiment, after the Ifo Institute’s monthly index of business confidence rose 1.1 points to 93, its highest level since February.

After inflation soared to a euro zone record of 7.4 per cent in April, far above the ECB’s 2 per cent target, a growing number of its governing council members have have signalled the first rise in its deposit rate for a decade is likely at its meeting on July 21.

Markets are pricing in four quarter-point rate rises by the ECB this year - one at every meeting from July to December. Rohan Khanna, a fixed-income strategist at UBS, said: "Every time any policymaker moves towards what the market is pricing, the market tends to price in a bit more."

The Dutch central bank chief Klaas Knot even said last week it could consider raising its deposit rate by half a percentage point at the July meeting, which would lift it from minus 0.5 per cent to zero in one go.

However, Ms Lagarde said gradualism was “a prudent strategy under uncertainty”, signalling a preference for quarter-point rate rises. “It is sensible to move step by step, observing the effects on the economy and the inflation outlook as rates rise,” she added.

The euro zone was “not facing a straightforward situation of excess aggregate demand: in fact, supply shocks are raising inflation and slowing growth in the near term,” she said. – Copyright The Financial Times Limited 2022