ECB on track to unwind stimulus after inflation warning

By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) -The European Central Bank confirmed plans on Thursday to end its hallmark stimulus scheme in the third quarter, worried that high inflation could become entrenched, even as the war in Ukraine left the outlook exceptionally uncertain.

The ECB has been unwinding support at a glacial pace, far slower than its peers, worried that growth could quickly crumble as the war, sky-high energy prices and the risk of losing access to Russian gas batter an already fragile economy.

Even on Thursday it maintained a non-committal tone, avoiding any firm pledge beyond the end of bond buys, stressing that policy is flexible and can quickly change.

"The downside risks to the growth outlook have increased substantially as a result of the war in Ukraine," ECB President Christine Lagarde said.

"We will maintain optionality, gradualism and flexibility in the conduct of our monetary policy," she said, speaking from home where she is recovering from the coronavirus.

But Lagarde also delivered a stark warning on inflation, noting that longer-term inflation expectations were showing early signs of moving above the ECB's 2% target.

Such a shift, called de-anchoring in central bank-speak, is a worrisome sign, suggesting markets' loss of confidence in the bank's ability to maintain price stability.

"The last thing that we want is to see inflation expectations at the risk of de-anchoring," Lagarde said, adding that "close monitoring" would be required.

While Lagarde largely avoided discussion of any rate hike, her comments that it could come "a week" or months after the end of bond buys suggest that policymakers could discuss the issue at their late July meeting.

Sources close to the discussion agreed, noting that a July rate move is still on the table but there were divisions in the Governing Council about risks, including on longer-term inflation prospects. [S8N2UQ05X]

JULY?

Economists meanwhile zeroed in on a later move but took note that Lagarde did not rule out a change in the minus 0.5% deposit rate during the summer, just before policymakers leave for their holidays.

"We still believe the ECB is unlikely to hike in July, but Lagarde wanted to make clear that the option was available," Pictet strategist Frederik Ducrozet said.

The ECB last raised interest rates over a decade ago and has kept its deposit rate in negative territory since 2014.

Markets now price in 63 basis points of rate hikes before the end of the year, a modest retreat compared with 70 basis points priced in prior to the meeting.

The euro meanwhile fell sharply as some expected Lagarde to unveil a more decisive schedule to tighten policy.

Carsten Brzeski, an economist at ING, also saw September as the more likely lift-off date.

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"We expect the ECB to stop net asset purchases in July and start hiking interest rates in September," he said. The ECB will definitely not get ahead of the central banks’ pack any time soon in terms of policy normalisation. It will be normalisation at a snail’s pace."

Among the world's most cautious central banks, the ECB is already lagging far behind nearly all its major peers, many of which started raising rates last year.

In the past two days alone, the central banks of Canada, South Korea and New Zealand have all increased the cost of borrowing. The U.S Federal Reserve is meanwhile expected to raise rates eight times or more over the next two years, leading the world in policy tightening. [TOP/CEN]

Part of the ECB's caution is that the drivers of high inflation now are likely to weigh on price growth further out.

Energy prices driven higher by the Ukraine war are draining household savings and uncertainty caused by the conflict is halting corporate investment. Banks are also tightening access to credit as they naturally do during wars, potentially exacerbating the downturn.