ECB Preview: More Hikes Needed – Now Makes Sense

Summary

• The ECB’s decision to hike is based on three factors:
  • Whether core inflation (and importantly wage-intensive services inflation) is trending towards target.
  • Whether the forecasts suggest the outlook is more/less hawkish than in June.
  • Whether policy transmission is feeding into the real economy.
• We expect each of these justifies more hiking, and (in line with our long-standing call), and we err towards this being delivered at Thursday’s meeting.
• The ECB will likely want to stress that most of the tightening has been completed, but that there is room for them to hike again if needs be.
• They will likely want to push back on market pricing for cuts in 2024.

Market Implications

• We continue to see value positioning for at least a 4% ECB terminal rate, and fading market pricing for 2024 cuts via paying EUR short-end rates.
• If the ECB fails to deliver, we expect it would attempt to position for a hawkish pause – whether this is credible or not will depend strongly on Lagarde’s presser – the risk would be skewed towards the market not seeing the guidance as credible.
• In such an instance we would look to quickly fade dovish market reaction on the expectation that a hike can still be delivered at the October meeting.

Room for More Tightening

Despite slowing Eurozone growth, our lean is that the ECB needs to tighten further to get inflation onto a trajectory consistent with their medium-term inflation forecast, and that they will choose to raise rates a further 25bp this week. This sits consistently with our longstanding expectation for terminal rate at 4.0%, with upside risk.

The Governing Council have been unequivocal that their hiking decisions will be data dependent. In particular this means depending on their assessment of:

• the inflation outlook (the forecasts)
• the dynamics of underlying inflation (are there signs that inflation is sticky)
• the strength of monetary policy transmission.

By our assessment, each of these factors supports further ECB tightening. Given that the ECB is updating its forecasts now, it makes sense for them to choose to raise interest rates this week to show that they are serious about their policy mandate.

If they do not (we set out tail-risk reasons why they may not below), it is likely that they will find it difficult to tread a sufficiently hawkish tone to convince the market they will hike again (remember, they are not in the business of forward guidance anymore). However, if that is the case, near-term data (including September inflation) should allow them to hike in October. As such, we would see value in fading too much dovishness being priced in.

The “upside risk” to 4.0% as a terminal rate within our outlook stems from the risk further down the line from strength in medium-term inflationary factors (strong employment, long-term higher energy costs, prospects for further fiscal expansion). Ultimately, if into next year inflation momentum does not fade, these could trigger further tightening after the pause.

Three Reasons to Hike Interest Rates

(1) Core Inflation Is Not Returning to Trend

By our calculations (based on the trend in seasonal adjusted MoM outturns), core inflation is on track to settle above 4% YoY, and downward momentum remains elusive (Chart 1). This is despite weaker momentum in August (more on that below). 

The ECB is keenly focused on the details of inflation. Consequently, while services inflation momentum is fading, wage intensive services inflation continues to rise, in tandem with negotiated wage growth (Chart 2). The latest PMIs suggest that firms may be becoming more willing to absorb rising wage growth within their profit margins (i.e., not passing on 100% to customers), but such outturns do not look likely to hit the hard data until Q3.  

August also provided a slightly smaller beat in core inflation than we saw in July (although, together this still suggests Q3 inflation was higher than the ECB had expected in June), but a large degree of this is likely down to the fact that August tends to see relatively little firm re-pricing in core sectors. In fact, it sees the least of any month.

The beats in seasonally adjusted inflation this year have so far roughly correlated with the typical repricing that each month usually sees (Chart 3). It is not a hard and fast rule (March was a strong exception), but it adds to our baseline expectation that September CPI offers the potential for a similar SA beat to that seen in July.    

(2) Forecasts Are Likely to Be Hawkish

The ECB will release refreshed forecasts on Thursday. The picture these paint, particularly in core inflation, will be critical to their decision whether to hike. A pause would probably require the medium-term outlook to have materially improved since June (otherwise they would have chosen to pause then). But this is unlikely to be the case. Recent comments from De Guindos suggest they will be similar to June forecasts, while reported leaks suggest that 2024 CPI will be raised >3.0% (from 3.0% in June). This would be in line with the European Commission’s upward revision to 2024 inflation (despite a lower growth assumption). If this was the case and 2025 inflation was kept at 2.2% (or increased) it would be a highly hawkish move. There is a chance they revise down the 2025 number in order to show progress. This would sap the hawkishness, but could be hard to justify.

For the medium-term forecasts, the most important aspect is the labour market (unit-labour-cost, ULC drove the June upgrade). On this front, the data since June has shown unemployment remaining below the ECB projected levels (Chart 5). Increasingly negative surveys actually add to the ULC pressures – they show firms are continuing to hire even while orders fall – a clear decline in productivity. 

For the ECB to decide that the ULC (and hence core inflation) outlook has reduced, they would need to conclude either that: (1) wage growth will be far lower ahead, or (2) labour productivity will be far higher. Neither outlook seems credible right now.  

(3) ECB Policy Transmission Suggests More Hikes Are Needed

Measuring policy transmission is a complicated matter. For the ECB to decide that they are able to pause hikes while core inflation remains so high, there must be sufficient pipeline tightening to come to significantly dampen aggregate demand.

We wrote recently in depth on the subject, and our conclusion was that while hikes continue to have a broad impact on bank cost of capital, and the cost of corporate borrowing, most of this has already fed through to the respective markets. Meanwhile, in the mortgage market, the situation is heterogenous. Rental caps have limited the passthrough of policy tightening to renters, and the experience of mortgage holders is highly country specific. Countries such as Spain have already seen almost complete feedthrough of the increase in mortgage costs, while those such as France and Germany have seen almost none. This leaves the ECB in a tight spot (one policy for so many economies), but neither outcome suggests that pipeline tightening will be sufficient alone. For the Spanish it suggests very limited pass through of tightening, while for France and Germany it suggests that the impact will take far too long to feed in.  

Dovish Risk: Weaker Growth Trajectory and the Voting Schedule

The ECB understands that the survey data have been less useful since COVID (we agree). Still, the overwhelming bearishness is hard to ignore. While (as we mentioned above), the weaker growth outlook alongside resilient employment is actually hawkish for ECB forecasts, the governing council may argue that tight labour cannot remain through such a recession as is being predicted. The ECB is almost certain to revise lower its expectations for growth, and this could weigh on the medium-term picture. However, for now we believe that this is insufficient to dissuade another hike. The ECB has one mandate: price stability, and has fought to retain credibility through the recent crisis. We expect they will err that way once again.

The voting schedule is not something we typically pay attention to in forecasting rate decisions. Unlike in the Fed, when rotations last a full year, the ECB ostensibly rotates its voters every month. They do not publish records of voting, and by all accounts decisions are generally reached by consensus, with the GC and major NCBs’ voices counting for the most. As such, the fact that September’s scheduled voters err on the dovish side should not be that important. Scheduled to miss the vote are hawks: Nagel (Germany), Wunsch (Belgium), and Müller (Estonia), as well as dove Stournaras (Greece) and neutral Makhlouf (Ireland). However, given that the decision is so closely in the balance there is a risk that it could sway the situation.

In such an instance, however, we expect that the hawks would return with a vengeance in October (likely strengthened by a strong September print), and be willing to throw their weight around when the rotation shifts to favour the hawks.

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. He holds a BA in Economics from Durham University, and an MSc in Economics & Social History from the University of Oxford.

(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.)