ECB Monitor: Looking Through Bumpy Disinflation

Summary

• We expect the ECB to cut twice more this year.
• However, within recent ECB comments on 2024 cuts, one more cut has emerged as most popular. Most important voices have yet to opine, though.
• The June ECB meeting minutes suggest general agreement that disinflation is underway and a broad capacity to look through bumps.
• Services inflation momentum remains high, but we expect wage-intensive services inflation momentum will drop in the months ahead.

Market Implications

• We still see value in EUR swap 2s10s steepening, targeting a return to disinversion.

Recent Comments

The recent trend in ECB comments is that the path for inflation remains bumpy but cuts can continue if the ECB’s baseline inflation forecast is met. At the last meeting, the consensus was broadly that inflation remains on track with forecasts, albeit with risk of stickiness.

More recently, ECB speakers have commented on how many 2024 cuts they expect (Chart 1). While the majority of the most important voices have yet to opine, many minor voice are mentioning or hinting at just one more cut, rather than two.

Our base case remains for two more 2024 cuts and that Fed hawkishness will make ECB dovishness more necessary. We expect the Governing Council to focus on inflation trends (not single releases) given the wide agreement on the ‘bumpy’ path back to target.

Recently, core inflation momentum has picked up, lifted by services inflation (Chart 2). However, the momentum in wage-intensive services inflation looks to have reached a near-term peak (Chart 3). We expect this to peak in summer and fade thereafter.

If this normalisation is realised, the ECB will be more comfortable with the return to target. 50bp of cuts should then become their central case. That should help our EUR 2s10s steepener perform (we target a return to at least disinversion).

ECB’s 6 June Meeting Minutes

Inflation

• Underlying inflation is easing, reflecting fading supply shocks and weaker demand. Despite surprises in April and May, disinflation continues.
• Inflation is expected to fluctuate around current levels in the near term, then decline towards target in H2.
• Services inflation and wage growth should decelerate markedly in 2025. Compression in unit profits are helping absorb wage growth.
• Scope for profits buffering wage rises is more restricted in services.

Labour Market

• Wage growth remains elevated. Stronger Q1 negotiated wage growth was due to large one-off public-sector pay rises.
• High nominal wage growth is expected to be moderated by a recovery in productivity and lower profit growth.
• More broadly, multi-year wage settlements specified high increases in 2024, but smaller increases are expected in 2025. Forward-looking wage trackers concur.
• Wage-sensitive services inflation continued to moderate.
• Alternatively, some sectors with high wage rises have also had high profits, which may allow them to continue to pay well.
• A higher wage growth profile was incorporated into the June projections, so little to no upward risk there.
• Labour strength has puzzled most – notably that there has not been more labour shedding

Risks Raised

• Spillovers of China growth policies: they could negatively impact EZ manufacturing growth, but could also have inflationary impacts if European production capacity was driven out.
• Deglobalisation: a risk but not visible in the data.
• Some doubts raised about whether the growth recovery can happen as expected as it depended on private consumption. The savings ratio could go even higher.

The Decision

• A 25bp cut was made due to the inflation outlook, dynamics of underlying inflation (domestic inflation), and strength of policy transmission.
• There was general agreement that disinflation can continue, as per projections (though it could be stickier than expected ahead), and that policy transmission remained strong (real rates close to peak).
• There was disagreement on whether risks are balanced or remained to the upside.
• Underlying inflation dynamics seemed to have improved, though domestic price pressures remain strong. It will take time to confirm if pressures are normalising.
• The 25bp cut still left policy restrictive. Stronger demand should not offset the return to target, and upside surprises could be offset with slower easing. A large external shock would be needed to reverse the cut.
• Some members felt data had not increased their confidence of inflation returning to 2% by 2025, pointing to greater inflation stickiness. They considered a small undershoot as less costly than a continued overshoot.

Appendix – Data and Surveys

1. Market stress remains relatively limited, suggesting that financial conditions are not overly tight (HAWKISH).
2. Market pricing for cuts have recently pared back.
3. The EZ economic surprise index has dropped back sharply, recently (DOVISH).
4. Outlook surveys for businesses and consumers have begun to stabilise below historic averages (DOVISH).
5. Labour market expectations have also deteriorated, although this has not fed through into the hard data yet (NEUTRAL).
6. Market and consumer inflation expectations have dropped back, although they remain above average. Analyst expectations are around target (NEUTRAL).

Appendix – Recent Comments

Henry Occleston is a strategist who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)