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ECB needs more rate hikes and faster balance sheet cuts, Wunsch says

FILE PHOTO: European Central Bank (ECB) headquarters in Frankfurt

By Balazs Koranyi

WASHINGTON (Reuters) - The European Central Bank should speed up the reduction of its balance sheet and could stop reinvesting cash from debt maturing in its largest bond buying scheme to complement further interest rate hikes, Belgian policymaker Pierre Wunsch said.

Fighting stubborn inflation, the ECB has raised rates at its fastest pace on record and has been shrinking its bloated balance sheet, all in the hope that more expensive borrowing will thwart demand and curb inflation.

"We need to do more on quantitative tightening," Wunsch, a member of the ECB's Governing Council, told Reuters on the sidelines of the IMF and World Bank spring meetings in Washington. "We could do a full stop of reinvestments this year and even with that, it will take years to run down the portfolio."

The ECB is now allowing 15 billion euros worth of debt per month to expire in its 3.2 trillion euro Asset Purchase Programme, and Wunsch argued that this process has gone well so far.

"The market has reacted very well, and our balance sheet is still too big," he said.

Wunsch, among the first last year to recognise Europe's inflation problem, also said the ECB needed to keep raising interest rates and the market's expectation for another 75 basis points of increases was "reasonable," but expectations of a rate cut around the turn of the year were not.

"I think May will be about 25 or 50 basis points," Wunsch said. "If there's another upside surprise in core inflation and the (ECB's quarterly) lending survey doesn't look too bad, we might have to do 50," he said. "If there is a positive surprise in core, then perhaps 25 is more appropriate."

Markets now see the ECB raising its 3% deposit rate to 3.75% by September, but then expect some reversal, contrary to the ECB's guidance that once rates peak, they would stay at that level for a while.

"Given that wage dynamics will be incompatible with the 2% inflation target for years and real rates are still low, I don't see any quick reversal of policy once we reach the terminal rate," he said.

The euro zone's biggest problem now is that underlying inflation is still rising and appears to be defying all expectations, suggesting that the ECB does not fully understand these price dynamics.

"What is really concerning is that in December we projected core inflation stabilising at 5% before its decline," Wunsch said. "We're now at 5.7%, and within a few months the deviation from that December projection could be 1 percentage point."

Core inflation is still going to come down, especially once the big falls in energy costs feed through, but there is a risk it could hold above 3% for a longer period, Wunsch added.

(Editing by Paul Simao)