ECB Monitor – September Decision in the Balance

Summary

• The market has come around to pricing a September pause, supported by media reports of momentum growing among policymakers for that.
• We would caution against reading too much from this alone – data is far from dovish, and this week’s inflation release will be key.
• Updated forecasts will be an important decider of the action taken – the ECB may have a hard time skewing these more dovish.
• President Lagarde’s speech at Jackson Hole was hawkish in the long-term, but is unlikely to reflect her views for the September meeting. It supports our belief that rates will need to remain elevated for some time.
• August core inflation will prove important. The market is expecting +5.3% YoY but there is little consensus on that. 5.2-5.3% would align with our expectation that August saw less repricing than July, but this will pick up again in September.
• The details will be key. A drop in YoY does not mean a lot given base-effects – focus on the MoM momentum.  

Market Implications

• As it stands, we are 50:50 between a hike in September and a pause. However, we continue to see the data supporting a terminal depo. rate of at least 4%.
• We see good value still in fading the cuts priced into 2024 via paying 6M forward 1Y EUR OIS and positioning for 2s10s EUR flattening vs GBP.

Current ECB Forecasts

Is the ECB on Track to Pause in September?

When the ECB last hiked, we warned that despite Lagarde’s confused tone, it did not mean that ECB is necessarily dovish (as the market is pricing).

Following the July meeting, the tone has diverged predominantly into two camps: the more hawkish members are ‘open’ to a pause or a hike and ‘data dependent’, while the doves appear more focused on the value of being ‘persistent’ (i.e., keeping rates high) rather than raising them further. Dove Panetta has written in depth on this. Either way, neither argument is particularly suggestive of 2024 cuts, which we continue to see value in fading.

Negative PMIs and more recent comments from the edge of the Jackson Hole conference have convinced the market that the base case is for a September pause, with the next CPI outturn important in determining whether or not this is the case. Much of this came about from Reuters reporting on conversations with eight anonymous policymakers. They noted:

• Policymakers are increasingly concerned about deteriorating growth prospects. And while the debate is ‘still open’ for September, momentum behind a pause is building.
• Several policymakers saw chances ‘evenly split’ between a September hike and pause, while a smaller number saw a pause as more likely.
• None said they saw a hike as most likely, even if that was their preference.
• All sources agreed that if they pause the ECB will make it clear that more policy tightening could still be needed.
• Sources agreed that nothing is settled until after the August inflation reading.
• Some cautioned against reading too much into surveys because there has been a growing gap between hard data and sentiment readings (we agree).
• Advocates of a pause argued that negotiated wage growth is still relatively benign.

We are careful not to read too much into the Reuters comments. Clearly, which eight policymakers gave their view is very important. By our own estimates based on recent policymaker comments (see appendix), the playing field is still very open, with the plurality backing a data/forecast-dependent approach come September.

There are several things we would note in the context of the Reuters article:

Core inflation is not settling at target. This seems to be policymakers’ primary concern. By our calculations, annualised momentum would have core inflation settle at +4.6% YoY at the recent rate. Downward momentum remains elusive (Chart 2).

Negotiated wage growth does not seem ‘benign’. Q2 data shows negotiated wages continue to grow strongly, in tandem with wage intensive services inflation (Chart 3).

Recession talk is being driven by weakening surveys, but they also noted that disparity was growing between surveys and hard data (as we have mentioned before). French services are a good example of this (Chart 4).

Comments around labour market tightness are interesting, too. They boil down to either: the labour market is too strong for disinflation OR “this time it’s different” (in terms of the relationship between employment and inflation). We would caution that the latter argument has already burned central banks (and the market) repeatedly through this inflationary crisis.

Lagarde Speaks on Long-Term Risks

Speaking at Jackson Hole, President Lagarde maintained the ’setting interest rates at sufficiently restrictive levels’ line she introduced at the last meeting presser, but sounded more hawkish than some recent policymaker comments on the longer-term inflation outlook. Included in this were the energy outlook, de-globalisation and AI effects on labour markets. She anticipates supply shocks will become more frequent, and investment will be front-loaded (in defence and energy). This will push central banks to focus on re-anchoring inflation expectations. She noted two hawkish developments since the pandemic:

• Firms have switched from avoiding price rises to retain market share to raising prices in tandem with competition. She noted a doubling of the frequency of price changes in some sectors versus pre-2022.
• Labour market tightness has left workers in a better position to bargain for higher pay. She implied second-round effects were being seen, or at least the risk was now elevated.

She concluded that these two impacts could continue ahead, driving inflation to become self-sustaining. She recommended three elements to deal with this:

1. Total, unwavering clarity on the inflation target and commitment to deliver it.
2. Flexibility in forecasts by using the inflation outlook, the underlying dynamics of inflation, and the policy transmission to assess the inflation outlook.
3. Humility in discussing the limitations of what they know and what monetary policy can achieve.

Overall, I would not try and to argue that her speech has hawkish implications for the September meeting, but it supports our expectation that rates will be higher for longer and that priced-in 2024 ECB cuts can be faded.

August CPI Key to Decision

The flash inflation outturn (31 August) will be a strong input into the ECB’s decision to hike or not at the September meeting. Expectations are fairly split between +5.2%, +5.3% and +5.4% for YoY core inflation (highest ranking forecasts skewed to the upside). Those outturns would, respectively, represent a MoM reading of +0.25%, +0.35%, +0.45% (Chart 5). In my view, the first (+5.2%; +0.25%) would represent a dovish outturn, the middle (+5.3%; +0.35%) would be balanced and the third would be hawkish (+5.4%; +0.45%), but the detail will be important regardless, as one-off aggregate readings will not alone decide whether the ECB hike or pause.

Our lean at this stage, given the large beat in July (when generally stronger repricing is seen), is that August core inflation will exhibit a smaller beat versus typical August MoM inflation than July did (Chart 6). That makes +5.2-5.3% YoY quite possible. However, September is likely to see more repricing, and hence higher chance of another strong beat at that time.  The ECB will know this and should take whatever read we get in that context.

Surveys and Financial Conditions Turning More Neutral

We find that surveys and data important to the ECB (in our appendix) remain hawkish:

• EZ systemic stress continues to fall back, decently down from H2 2022 highs or the highs seen post-SVB (Chart A1). HAWKISH
• Market pricing remains around 4% (our base case), however, the cuts priced 12 months ahead can fade. HAWKISH
• Data surprises remain suppressed but have bounced more recently (Chart A3). DOVISH (but less than previously)
• Consumer confidence continues to recover (albeit at low levels), while expectations of business orders continue to trend down, led by Industry and Retail (Chart A4). DOVISH
• Hiring/employment remains positive (Chart A5). The labour market remains tight (Chart A5). HAWKISH
• Inflation expectations look to be returning towards 2% (Chart A6). HAWKISH

Appendix: Stress, Surveys and Economic Data

Recent Policymaker 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.

Photo Credit: depositphotos.com

(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.)