ROI-Will ECB's 'good place' turn into passive easing?: Mike Dolan

By Mike Dolan

LONDON, Dec 9 (Reuters) - European Central Bank hawks determined to resist further interest rate cuts are starting a drumbeat for future tightening by conjuring up a new specter: passive policy easing.

ECB board member and renowned hawk Isabel Schnabel spooked the bond market on Monday by saying the next move in euro interest rates is more likely to be up - even if not on the immediate horizon. Her reasoning was eye-catching: leaving rates unchanged for too long would, by osmosis, amount to an unwarranted loosening of monetary policy.

In other words, the ECB would need to track a likely rise in euro zone's long-run "neutral" interest rate just to keep the economy on an even keel and policy in its much-prized "good place".

This year has been atypical for the ECB in many ways.

Even though it cut its main deposit rate in four quarter-point instalments to 2% in 2025, 30-year benchmark German government bond yields moved almost as much in the opposite direction, and the euro's effective exchange rate rose almost 3%.

For that, markets largely blame U.S. President Donald Trump's global trade and defense disruptions and Germany's extraordinary post-election fiscal boost, which has yet to kick in fully - among other factors.

For now, however, the ECB's "good place" claim is broadly warranted by most metrics. With headline inflation just above 2% and forecast dip slightly below that over the next two years, the real, inflation-adjusted policy rate is near zero - roughly where many place the euro zone's long-term neutral rate.

What's more, there is mounting consensus among ECB officials not to obsess about fine-tuning rates or overreacting to small deviations in inflation or market expectations.

That effectively bakes in policy stasis for some time. Market pricing certainly appears to have taken the cue: no move in either direction is priced for at least the next two years and only minor rumblings of a shift in the last quarter of 2027. Even Germany's Deutsche Bank late last month pushed back its forecast for a first ECB rate rise to mid-2027 from the end of next year.

However, these are still turbulent times, with many structural shifts in the global economy unfolding and considerable focus on just where the elusive neutral rate - so-called r-star - might be.

CREEPING R-STAR

Schnabel's point on Monday was that if you do nothing for too long, policy drifts onto easy street - a risk she sees as unwarranted given the trajectory of the wider euro economy, ongoing fiscal expansion and underlying wage and credit growth.

"I believe that we could see an increase in the natural rate of interest, related to what's happening in the area of AI and with regard to public investment," Schnabel told Bloomberg. "Of course, we don't have a tool to estimate 'r-star' precisely in real time. But if it were to increase, a constant policy rate would lead to more accommodation unless inflation were to drop at the same time to the same degree."

"We have to monitor whether our policy becomes more accommodative over time, and potentially too accommodative, which would then be a time to think about another rate move," she added.

Just how realistic is the Schnabel scenario?

ECB economists tend to put the unobservable r-star in a tight range around zero and other models broadly concur.

The New York Federal Reserve's estimate of internationally comparable r-star levels - the Holston-Laubach-Williams model - puts the euro zone's real neutral rate at just 0.2%, albeit with wide uncertainty bands.

If that were to persist, then the ECB's happy place might too - leaving current settings with a real rate of minus 0.2%, stimulating the economy a touch and tallying with the mild inflation undershoot in standing ECB forecasts.

But that model has been more volatile than you'd imagine in recent years - with the current 0.2% estimate half what it was just before the COVID-19 pandemic and a quarter of the 0.8% estimate just two years ago.

If euro r-star were to return to that early-2023 level over the next year or two, and inflation stayed on target, unchanged ECB rates would become some 80 basis points more accommodative over that period - exactly the sort of passive easing Schnabel wants to flag.

As to whether that's likely, there are studies that say a combination of simultaneous shocks from AI, rearmament and deglobalisation could well lift r-star sharply in the years ahead.

But, as ever, there are multiple crosscurrents in Europe that give the more dovish officials and forecasters some hope.

Chief among them could be the possibility of further extraordinary strength in the euro - not least if fears of political influence on the Federal Reserve were to trigger sharp U.S. rate cuts next year.

What's more, November Chinese trade data this week showed evidence of significant rerouting of exports away from the U.S. and more toward other Asian economies and Europe - the kind of potential flooding of European markets with cheap imports that many have feared might result from a U.S.-China trade war.

If that deflationary force builds and proves persistent, the risk of euro zone inflation undershooting target is far greater than current ECB forecasts assume.

Add in uncertainty about the impact of the German fiscal boost, or even the chance of an end to the Ukraine war, and markets may be wise to keep all bets on future ECB moves on hold after all.

The opinions expressed here are those of the author, a columnist for Reuters

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(by Mike Dolan; Editing by Marguerita Choy)