Monitoring the ECB: Dispelling Dovish Dissent

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Summary

• As we had expected, the recent tone of speakers and the tone of discussions within the December meeting minutes suggest limited room for a slowdown in hiking ahead. We continue to expect terminal rate at 3.5% or higher.

Current ECB Forecasts

Link to Most Recent ECB Meeting Minutes (Dec 22)

Comments and Minutes Reject March Hike Deceleration

In our last report, we noted that the European Central Bank (ECB) seemed to be on autopilot for 50bp for the next two meetings despite ECB sources suggest the doves were discontent with President Lagarde’s approach. Since then there have been further reports that doves would be pushing for 25bp hikes from March, and the market has pared pricing. However, as we had expected, subsequent comments from the likes of Lagarde, Chief Economist Lane, France’s Villeroy, and the Netherlands’ Knot, have strongly pushed back on this sentiment. Meanwhile, the December meeting minutes point towards the hawks having wanted more at that time and but having had to compromise.

The substance of the minutes suggests a picture largely in line with our expectations of discussions back in December – namely that there would be a strong push within the Governing Council (GC) for a larger hike (we saw 75bp as being possible) and heavy QT. The tone around economic forecasts showed a great deal of uncertainty, as well as growing concerns around the effect of fiscal policy and second-round wage impacts. As stated in our last report, we expect it will be these factors that keep members hawkish.

The main conclusions from the minutes were:

• 50bp was presented by Board Member Lane as a sustainable pace for tightening, allowing the GC to tighten over a ‘longer period’.
• 75bp was favoured by a ‘large number’ of members, but 50bp was accepted if the communication would be altered to say the GC would raise rates significantly at a sustained pace. Their rationale for 75bp was:
  • Persistence of inflation into 2024 suggests inflation not only supply driven.
  • Forecasting such a miss and not taking strong action against it would hurt ECB credibility (and make their job harder).
• The decision against 75bp was, in part, due to concurrence of announcing QT.
• Some wanted the APP reduction to be faster. The moderation was justified by preventing bond fragmentation.

Taking this, alongside the recent comments from GC members, I remain strongly of the view that the ECB will hike 50bp in February and March, and likely need to continue tightening thereafter.

Surveys and Financial Conditions Support Hawkishness

Our expectation for sustained hawkishness is supported by survey and financial condition data (see Appendix). ECB measures of systemic stress have recently declined as periphery/core spreads have tightened in the recent bond bid. Meanwhile, European economic surprises have continued to diverge positively from China and the US (albeit China has caught up somewhat after its reopening). With the fading of near-term gas shortage worries, surveys across businesses and consumers in activity and employment have bounced. Meanwhile, inflation expectations have continued to rise, particularly in the near-term, but with clear signs of feeding through into the medium-term (3Y ahead expectations are stable at record highs of 2.2%).

As a result, while the case for dovishness could build if inflation starts to slip, consensus within the voting members should begin to turn towards the deterioration of the medium-term outlook. As such, the case for a terminal rate above 3.5% seems significantly stronger than one below it.

Recent Voter Comments

Appendix: Stress, Surveys and Economic Data

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.)