MNI SOURCES: Doubts Over EU Carbon Pricing Key For ECB Rates

Questions over the future of the European Union’s new carbon-charging scheme, which is set to add significantly to inflation from 2027 onwards, will be a material factor in determining whether the European Central Bank can extend its current easing cycle, Eurosystem sources told MNI.

Assumptions over the ETS2 regulation extending the EU’s emissions-trading regime to household heating, road transport and small businesses have contributed about 0.3 percentage points to the ECB’s projection for inflation to rise to 1.9% in 2027, but there is an increasing likelihood that the European Parliament will dilute or delay its impact, sources noted.

“If ETS2, for political reasons, either doesn't happen or is significantly watered down, there is an undoubted impact on the projections for 2027 and probably into 2028,” one official said. (See MNI: EU Likely To To Limit Fuel Price Hit From ETS2 CO2 Scheme)

 A downgrade to ETS2 would almost certainly prompt a second year of marked undershooting of the ECB’s 2% target, with inflation projected to decline to 1.7% next year, several sources noted, though other factors will also figure prominently in Governing Council decisions over whether to take the deposit rate below its current 2%.

“That is certainly another significant downside inflation risk at present, along with the disinflationary impact of a stronger euro and the potentially deflationary impact of rerouted China goods,” an official said. (See MNI SOURCES: Data-Led ECB To Hold A Cut In Reserve If Needed)

LONG-TERM SHIFT

However, not all officials agreed that the impact of otherwise of ETS2 should be central to the ECB’s deliberations. 

“My view on this argument is pretty simple: such a measure would mean a one-off shift, or the absence of an expected one-off shift, in the price level... the kind of stuff one looks through,” the official said.

The effect of any changes on inflation projections for 2028 will be particularly important, another official said.

The ECB could only incorporate any ETS2 downgrade into its calculations once it is enacted in legislation, officials said, with one noting “we are tied with what we have, and, being the EU, any amendment is certain to be later rather than sooner.”

 Another, though, feared that the carbon-pricing regulation could be part of a structural shift in the eurozone economy to permanently higher inflation.

“This is the million-dollar question that goes beyond the ECB. Because what is being discussed at its core is whether we are in a new world where inflation is secularly higher or whether we will return to the world just before the pandemic with a negative natural rate,” the source said, adding that he tended towards the former viewpoint, and anticipated a scenario where ECB rates normally vary between about 2% and 4%.
Still, he added, “I don't rule out that the eurozone could enter in a deflationary trend, with persistent undershooting. The risks to inflation are balanced because they depend on variables that we don't use the market curve for projections. Such as the exchange rate.”

An ECB spokesperson declined to comment.