ECB Preview: Could Even June Be Too Soon to Cut?

Summary

• We expect the ECB will keep its policy rate unchanged with the deposit rate at 4.0% this week.
• The market expects the ECB to downwardly revise 2024 core CPI. However, given the recent uptick in core and services momentum, there is an underpriced risk that they wait before such a downgrade.
• Labour market tightness has outpaced ECB expectations – this will likely mean higher ULC and upward pressure in medium-term inflation.
• We expect President Lagarde to reiterate the need for data dependency and patience before claiming victory in the battle against inflation.
• We still see June as the earliest the ECB will cut – but there is more risk than the market is pricing that they start later.

Market Implications

• We have recently taken profit on our April ECB ESTR payer. With the market 90% priced for a June cut, we are assessing the value of fading this pricing, too.

ECB to Reaffirm Patience

The ECB will announce policy and update its forecasts tomorrow. Within these, they must encompass the continued surprising tightness of the labour market and the upside surprises in Q1 inflation.

The inflation outlook is in the balance. Analysts expect the ECB to downgrade 2024 YE core inflation, which would align with our forecasts (Chart 1). However, there is an underpriced risk that they wait on this given the recent upside surprises. More generally, we expect Lagarde to restate the need for patience and data-dependence after the recent uptick in core and services inflation momentum.

The market is currently pricing a 90% chance of a 25bp June 2024 cut. We think there could soon be value in fading this pricing, given the risk of future upside data surprises.

ECB Can Downgrade 2024 Core Inflation, But May Wait

February core inflation was stronger than market consensus, as we had expected. However, we expect there could be downside risks to the H2 ECB core forecast (Chart 1). And the market seems to largely expect this downward revision. However, there is a risk that the governing council may not want to revise down their forecasts just yet, given the tick back up in momentum in services and core inflation in Q1. For now, their December forecasts for Q1 and Q2 core CPI still look achievable.

The uptick in Q1 inflation will concern the hawks, but it will be positive for the credibility of ECB forecasting. We expect them to emphasise this win. Additionally, they will reaffirm their commitment to data-dependence. We think that means they are waiting for Q1 inflation and wage negotiation data before choosing whether to cut.

While the market has now largely priced out an April cut as we expected (we took profit on our April payer), there is risk of further pushback. A June cut (c.90% priced) relies on relatively benign Q1 data. There is probably more than a 10% risk that this does not happen.

The risk ahead is to the upside in services inflation. In particular, wage-intensive services may see a further rebound as accommodation prices tick back up (Charts 2 and 3).

ECB June Cut Needs to See Sufficient Wage Deceleration

For the ECB to cut in June, they must first see a return towards more typical levels of wage growth in Q1. While a drop in YoY growth is likely, more timely metrics suggest wage growth pressures remain strong:

• YoY Indeed wage growth ticked up in December and January (Chart 4).
• Wage-intensive services inflation tends to lead negotiated wage rises, which makes sense given the data is timelier. It suggests wage growth will tick down in Q1, but then find support at elevated levels.
• February Services PMIs suggest even where output continues weakening (Germany), the positive outlook is supporting employment and wage growth.

Labour Market a Major Sticking Point

The Eurozone labour market remains secularly tight (it has consistently beaten ECB forecasts since the end of 2022, Chart 6). The ECB must now revise down its forecasts for unemployment again. If there is not also an upward revision in GDP, ULC will likely need revising higher too. That means greater medium-term core inflation pressure.

Fiscal Policy a Medium-Term Risk

For now, the Eurozone countries continue indicating relative fiscal tightness. This looks unsustainable given pressures to industry from US and Chinese competition (particularly in Germany), uncompetitive energy prices, and the need to rebuild a defence industry base.

The European Commission recently announced its European Defence Industrial Strategy. It is small fries right now in total spending (€1.5bn during 2025-27) but supports our case that such spending plans (both pan-European and national) are gaining traction.

The ECB must consider this when analysing the risk to the medium-term inflation picture.

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.)