Monitoring the ECB: Hawkish Arguments Remain Strong

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Summary

• Since our last ECB monitor (within our December ECB preview), as expected the tone has moved significantly more hawkish. We see the hawkish tone continuing, with 50bp likely at the next two meetings, and a terminal rate >3.5%.

Current ECB Forecasts

Link to Most Recent ECB Meeting Minutes (Oct 22)

50bp Autopilot for Now

As expected, given where ECB forecasts are pointing (see above), the recent tone in policy-maker comments has shifted towards the view that the ECB need to continue hiking at 50bp through, at least, February and March. In the near-term, this largely aligns with my view: they need to hike to at least 3.5% (Chart 1). Important comments on this front include: Chief Economist Lane’s and Austria’s Holzmann’s comments that core inflation will need to drop before slowing hikes, France’s Villeroy’s that the terminal rate won’t be reached until Summer, Estonia’s Müller’s that hikes will need to go beyond market expectations, and Latvia’s Kazāks’ that next two meetings need significant hikes.

Yesterday saw a report on discontent amongst doves at Lagarde’s December presser suggestion that 50bp per meeting was the path ahead. More broadly however the tone among doves has been one of concession. For instance, Greece’s dove Stournaras appears to be accepting that rates might reach 3% in March, while Portugal’s Centeno sees no alternative to further rate hikes.

Medium Term Inflation Outlook Deteriorating

The continued momentum in core inflation is very important at the moment. While it remains high and rising the arguments for slowing the hikes is weak, and will likely remain contained to Doves’ hopes rather than expectations. December’s preliminary outturn showed that MoM momentum remains decently above historical averages (Chart 2). For the ECB to be comfortable that its hikes have been sufficient, they would likely need to see several months of more normal or below-average core inflation. Therefore, even if price growth does begin to slow from here, the ECB is unlikely to have enough of a series to prove it until after March’s decision (by then they will still only have preliminary February data).

If core inflation is falling by March, the question will be what the updated forecasts look like. The risk here is that by then the medium-term core inflation outlook may actually be worse. There are several reasons for this:

• Future wage rises are a worry (growing proportion of wages indexed to inflation, forward-looking wage growth is high and rising).
• Non-targeted government spending also has the ECB concerned – accounting for 80% of 2023 energy measures, by ECB calculations. There may be further spending rises in response to the US’s Inflation Reduction Act.
• The threat of ‘greenflation’ remains. Schnabel spoke on the energy transition’s inflationary effects in early 2022. And this week, at the Riksbank’s symposium, she added new comments on how high inflation might derail the green transition and keep electricity bills elevated.
• The growth outlook has improved after the mild winter and reduced fears of near-term gas shortage. This could wipe away what little disinflation the ‘short-lived, shallow’ recession may otherwise have had.

In other words, the ECB is looking into a faster growing EZ economy facing more serious supply side price pressures at a time when fiscal policy is loose and loosening.

Surveys and Financial Conditions Support Hawkishness

The sustained hawkishness is supported by survey and financial condition data (see Appendix). ECB measures of systemic stress have declined recently as periphery/core spreads have tightened in the recent bond bid. Meanwhile, European economic surprises have diverged positively from China and the US, and (with the fading of near-term gas shortage worries) surveys across businesses and consumers in activity and employment have bounced. Inflation expectations continue to rise, particularly in the short-term, but with clear signs of feed 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 Voters 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.)