The European Central Bank will focus on shrinking its balance sheet as markets bet on interest rate cuts –

Christine Lagarde, President of the European Central Bank (ECB).

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FRANKFURT – The European Central Bank is meeting this week with investors who are closely watching when the Frankfurt institution might start cutting interest rates.

It will be too early to declare victory in the fight against inflation, but with inflation at its lowest level in two years, it certainly gives the Governing Council some breathing space to focus on another important issue: their gigantic balance sheet.

“Having reached its key interest rate plateau at a deposit rate of 4%, the ECB can now shrink its balance sheet more quickly without risking too much of a breakout in yield spreads within the euro zone,” Berenberg’s Holger Schmieding said in a study note for clients.

“Still, markets are likely to have to revise some of their over-optimistic rate cut expectations once the ECB speaks this Thursday.”

Inflation fell to 2.4% in November and core inflation also fell. With inflation falling faster than expected, investors have increased their bets on ECB rate cuts next year, especially after Isabel Schnabel, one of the more hawkish board members, called the fall in consumer prices “remarkable” and “a pleasant surprise,” according to a transcript of an interview with Portal on December 1st.

Money markets are currently pricing in interest rate cuts of almost 150 basis points next year. The bank’s key deposit rate is at a record high of 4% after making 10 consecutive hikes in July 2022, pushing rates into positive territory for the first time since 2011.

“The risk now is earlier and larger cuts and an ECB that is better able to decouple from the Fed,” said Mark Wall, ECB watcher at Deutsche Bank.

However, he is convinced that the ECB will most likely not lose sight of its cards: “We assume that the ECB will stick to its forecast that maintaining restrictive interest rates for a sufficiently long period of time will bring inflation back to the target value in a timely manner will bring.”

Looking ahead, March will see a new round of expert forecasts for inflation and economic growth, giving the central bank more data to underpin its data-dependent policy approach and potentially room to cut interest rates.

But this week the most important policy change at the conclusion of Thursday’s ECB meeting could come in the form of a shift in forward-looking guidance – particularly if the ECB ends reinvestments in its PEPP program.

The PEPP (Pandemic Emergency Purchase Program) is a flexible bond purchase program introduced during the coronavirus pandemic. The ECB is reinvesting all maturing securities it receives from its PEPP portfolio, but that could soon change.

“We have indicated that we will continue to invest until at least 2024,” ECB President Christine Lagarde told MEPs on November 27.

“This is a matter that is likely to come up for discussion and consideration by the Governing Council in the not too distant future and we may reconsider this proposal.”

Deutsche Bank’s Wall explained: “If interest rate cuts progress, the ECB could accelerate the first steps towards exiting PEPP reinvestments.”