By Francesco Canepa and Balazs Koranyi
FRANKFURT (Reuters) - The European Central Bank eased the pace of its interest rate hikes on Thursday but stressed significant tightening remained ahead and laid out plans to drain cash from the financial system as part of a dogged fight against runaway inflation.
After being wrong-footed by sudden price rises, the ECB has been raising rates at an unprecedented pace. Inflation has soared since economies reopened after the COVID-19 pandemic, driven by supply bottlenecks and then surging energy costs following Russia's invasion of Ukraine.
In a move shadowing similar steps this week by the Federal Reserve and Bank of England, it raised the rate it pays on bank deposits by 50 basis points to 2%, moving further away from a decade of ultra-easy policy.
That decision, which was expected, marked a slowdown in the pace of tightening from 75-basis-point increases at each of the ECB's two previous meetings, as price pressures show some signs of peaking and a recession looms.
But to secure a majority for that slowdown, ECB President Christine Lagarde had to offer dissenters a pledge that rates will be increased again, potentially as many as three times, by the same amount, sources told Reuters.
"Based on the information that we have available today, that predicates another 50 basis point rise at our next meeting and possibly at the one after that, and possibly thereafter," Lagarde told a news conference following the rate announcement.
Money markets immediately moved to price in a peak deposit rate of just over 3% by July, compared to 2.75% before the meeting.
The ECB is pushing hard to persuade investors of its commitment to fighting higher prices after lagging the Fed and BoE in raising rates.
But this return to giving a specific guidance on rates puzzled some ECB-watchers because it clashed with the bank's insistence that it will take decisions "meeting-by-meeting" and depending on data.
"There is an intrinsic contradiction here no words can resolve," said Francesco Papadia, a former top ECB official who is now a fellow at the Bruegel think tank.
Justifying Lagarde's pledge for more hikes, the ECB's new projections on Thursday showed inflation above the ECB's 2% target through 2025.
And Lagarde said inflation may still come in higher than that, citing the possibility of a bout of stronger-than-expected wage growth and of a boost to demand from government support measures across the 19 euro zone countries.
But those forecasts were disparaged as "euphemistically controversial" by none less than the ECB's former vice-president Vitor Constancio, who doubted that inflation could remain as high as 3.4% in 2024 even as prices including oil decreased.
"The problem, though, is that these December projections commanded by national central banks (Bundesbank etc…) have a lot of non-model 'judgement'," the Portuguese economist said on Twitter.
The ECB also said it currently expected any recession to be "relatively short-lived and shallow" and Lagarde noted that euro unemployment levels were at "rock-bottom".
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QT COMING
The ECB also laid out plans to stop replacing maturing bonds from its 5 trillion euro ($5.31 trillion) portfolio, reversing years of asset purchases that have turned the central bank into the biggest creditor of many euro zone governments.
Under the plan, it will reduce monthly reinvestments from its Asset Purchase Programme by 15 billion euros starting in March and revise the pace of balance-sheet reduction from July.
The move, which mops up liquidity from the financial system, is designed to let long-term borrowing costs rise and follows a similar step by the Fed earlier this year.
The impact was immediately felt by the euro zone's weakest borrowers, such as the Italian government, which have come to rely on the ECB as a major buyer.
The yield on Italy's 10-year bonds rose by 31 basis points to 4.19%, the biggest single-day change since the pandemic-induced market rout of March 2020.
"The reduction in the ECB's balance sheet, when combined with... greater fiscal spending needs in the wake of the ongoing energy crisis, could renew upward pressure on sovereign bonds in the euro area," Daniele Antonucci, chief economist at Quintet Private Bank, said.
The ECB said it would update the market on the "the endpoint of the balance sheet normalisation" by the end of 2023, indicating by how much it plans to reduce liquidity in the banking sector.
This is key for determining the cost of funding for banks and therefore the interest rates for companies and households.
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($1 = 0.9413 euros)