ECB Review: Confusion Does Not Mean Dovishness

Summary

• The ECB hiked 25bp at their July meeting and confirmed that their September decision will be based on policy transmission, data, and what the September ECB forecasts say.
• We would advise not trying to read too much into President Lagarde’s confused comments at the press conference.
• The most important question is whether the drivers of ECB decision-making have shifted enough to allow a September pause. We do not think this is the case, especially after the July inflation print.
• We continue to expect a further 25bp hike in September, with the risk of more to follow thereafter.

Little Surprise From ECB

As expected, the ECB hiked 25bp, with the focus remaining on the three points:

1. policy transmission,
2. underlying inflation, and
3. future economic forecasts.

A slight surprise came from the cut to the remuneration on required reserves to 0% (from the deposit rate, previously). That will mean lost EZ bank income of around €6.1bn per annum (3.75% x €164bn excess reserves) versus if they had not cut the rate. It is a negative to banks, but not a significant one, undertaken as an efficiency measure, not a monetary policy stance.

Otherwise, the statement proved mundane. The ECB slightly changed wording around its interest rates, with a shift from ‘…key ECB interest rates will be brought to levels sufficiently restrictive…’ to ‘key ECB interest rates will be set at sufficiently restrictive…’ (emphasis our own). This was done to stress the data dependence of future decisions.

Lagarde Returns to Waffling

The press conference marked a return to the ‘old’ Lagarde – muddled and confused, with a lot of waffle. We are ignoring the noise and concentrating on the fact that the ECB is data-dependent in September (which we knew going into the meeting). Nevertheless, the market has (probably erroneously) latched onto some remarks, so it makes sense to give an overview:

On Monetary policy:

• Lagarde: The decision to hike was unanimous, and there was no discussion on further balance sheet reduction.
  • Opinion: this is not that surprising, given previous ECB comments.
• Lagarde: At this point in time there is not more ground to cover, but the data and the forecasts will tell the ECB how much more ground to cover there is later; it may vary one month to another.’
  • Opinion: we would warn against interpreting this as meaning this is the peak, and instead take it as Lagarde saying: we did 25bp now as that was needed – if they needed to do more, we’d have done more. This is an old assertion from Lagarde to explain why they prefer to do multiple 25bp hikes rather than fewer 50bp.
• Lagarde: Repeated assertions that they need to ‘’break the back’ of inflation.
  • Opinion: this felt more like a wish to return to the definite hawkishness of June, rather than an actual return there.
• Lagarde: a ‘decisive maybe’ on whether to hike in September. She is leaning neither way, and the ‘burden of proof’ on all data, including forecasts.
  • Opinion: we take this as they are not just driven by headline/core, but the detail. In other words, nothing new.
• Lagarde: if they pause may not be for an extended period of time. The decision to hike vs pause will vary meeting by meeting.

On Data:

• Lagarde: domestic price pressures from wages and profit are increasing as a driver of inflation. Focusing on services inflation in wage intensive sectors.
• Lagarde: wage and profit both playing an increased role in inflation. Forecasts right now assume profit margins wide enough already to absorb wage growth.
• Lagarde: she avoided questions on whether unemployment needs to rise. Gave a ‘hope’ that they can meet mandate with unemployment low.
  • Opinion: this ‘hope’ seems at odds with the ULC driving core inflation in their forecasts.

On Policy transmission:

• Lagarde: beginning to see policy transmission from markets to the real economy. But also, financing leg has seen a lot on transmission, not so much for the broad economy.

As stated above, the conclusion is the ECB is data dependent. There is not much more that can reasonably be taken from the comments.

This is in line with our latest ECB monitor, and we will continue to focus on the data ahead. For now, our conclusion is that the ECB should hike at least once more, and not cut in 2024 (hence our bias towards short-end EUR payers). To understand this, let’s boil down to the three elements the ECB is focused on:

1. Is inflation falling back to target?
2. Will the recent decline in economic data skew ECB forecasts back towards target?
3. How strong is policy transmission?

Inflation Momentum Remains Robust

Core and services inflation surprised to the upside of ECB forecasts in June and July. The trajectory for headline is downwards in the YoY, but it is more informative to look at MoM (Chart 1). Much of the recent YoY upside in core was down to base-effects from last June (which will fade from September), but the MoM deviation remains strongly positive (Chart 2).

The story for services is hard to parse from the headline alone (YoY rise continues, but MoM has been more varied). Instead, we assess momentum across the index’s individual contributors by taking a three-month sum of the deviation vs a typical month (Chart 3).

This underlying story is hawkish. We do not have the detailed picture for July yet, but we can see that the disinflation out to June was driven by declines in MoM package holiday, communications and non-energy utilities. The contribution of wage-intensive services is meanwhile growing, driven by hospitality (Chart 3) This should be a concern to the ECB.

July CPI suggests this momentum is unlikely to fade by September. Further out, continued strength in wage growth will concern the ECB. As we have yet to see the growth there peak, it is unlikely that their impact on inflation has fully fed through either (Chart 4). Any offset from falling corporate profit margins that the ECB may be hoping for also looks unlikely (Chart 5).

The Economy Is Not Slowing Enough

It is easy to find evidence that will justify EZ economic weakness. Data surprises are at extreme lows, consistent with the GFC (Chart 6). Meanwhile, PMIs have crashed to similar historical extremes: with the manufacturing reading at just 42.7.

Previously, we have covered how the PMIs have become less useful in the post-COVID period. However, other surveys show similar negativity (particularly in manufacturing). On this front, it is worth stressing two things:

1. Manufacturing is only a small part of the Eurozone economy;
2. The outlook for employment (a key driver of ECB hawkishness) remains strong.

Through Q1, the manufacturing industry provided around 20% of the Eurozone economy, and around 14% of EZ employment. Using the European Commission’s surveys and weighting by GDP contribution, the overall score (retail, manufacturing, services and construction) dropped negative in the July reading but remains far from the lows seen in ’09, ’12 or ’20.

Meanwhile, the future employment component remains decently positive (Chart 7). Together, this suggests a slowdown rather than a crash, with continued support for the labour market.

Weaker Core CPI Forecast Needs Weaker Labour Market

At the June ECB meeting, core inflation was strongly revised up, driven by higher unit labour costs (ULC, a result of higher wage growth and slower productivity, Chart 8). The reason it wasn’t even higher was the expectation that profit margins will come down, absorbing some of the wage growth.

If anything, the slowing economic growth story, alongside the strong labour market, should support slower productivity growth than baked into ECB forecasts.

For the September ECB forecasts to be less hawkish, we would need some combination of:

• lower wage growth than estimated in June;
• higher labour productivity than estimated in June;
• faster falling profit margins than estimated in June.

At this stage, the data does not support any of the above. Meanwhile, although the 2023 growth outlook has deteriorated (as reflected by analysts’ expectations), the outlooks for 2024 and 2025 have been stable for some time (Chart 9). ECB forecasts for 2024 overshoot analyst consensus, but this is not a new thing.

Is Policy Transmission Strong Enough to Turn the Dial?

We covered this in our recent ECB Monitor, but we dive deeper in the near-future. At this stage, the evidence is somewhat weak to suggest that enough has been done. As such, we anticipate that the market will gradually price increased risk of tightening beyond 4%, and price out the risks of 2024 cuts.

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.)