ECB Council Meeting Review: Transmission Mechanism Now Acting Forcefully as ECB in Hold Stance
Bottom Line: The cumulative and sizeable rate hikes at each of the ten previous Council meeting has now been informally ended with the deposit rate left at 4.0%. Thus time around the (very much expected) decision was unanimous albeit largely repeating the changed rhetoric that first surfaced last month. This still leaves official rates at the highest in ECB history and encompasses a cumulative hike of 450 bp, also unprecedented and taking a toll on both demand and most measures of underlying inflation (Figure 1). Equally unsurprising, the ECB has effectively diluted any tightening bias, with Lagarde using the press conference to underline policy is now ‘holding’. ECB rhetoric again implies no early easing even though it has maintained an alleged predisposition that it will be data dependent. However, with this in mind, we still think ECB rates may start to fall by Q2 next year, as the ‘tilted to the downside growth risks’ the ECB accepts increasingly materialize and force the ECB to revisit its over-optimistic economic outlook.
Policy Considerations
This outlook is recognized by the ECB to some degree not only by the manner in which the Council has now swung fully in favor of stable policy. But it is also in more clearly accepting that the transmission mechanism is working faster and more strongly than in previous cycles, now described as acting forcefully with the Q&A and even acknowledging the ensuing risks to financial stability. It is the transmission mechanism’s ever-clearer power that persuades up to continue seeing a much weaker growth picture than the ECB’s ‘current assessment’, and on as sustained basis, which we think will deliver inflation back within target maybe even by end-2024. All of which persuades us that the ECB has presided over an extensive tightening but also an excessive one!
Figure 1: Persistent Price Pressures Slowing Sharply
Source: ECB, PCCI=Persistent and Common Component of Inflation
ECB Still Too Optimistic
As for conventional policy, clearly the ECB is hinting that rates have peaked but also that they will stay at least at current levels for some time without calling any formal pause or peak in policy. Echoing fresh rhetoric that surfaced at the last (September) press conference, it was noted that ‘key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target’. This language continues to give the ECB policy flexibility. Of course, suggesting no early easing is based on the economy matching the ECB current assessment, something we think is very optimistic not least given ever weaker business survey data.
Unconventional Uncertainty but No PEPP Talk
In contrast to some thinking, nothing new was flagged in regard to unconventional policy, still suggesting the ECB will continue PEPP reinvestments until at least the end of 2024. There had been some speculation that this timetable would be brought forward or at least that a discussion on this may have been initiated. This unwillingness may reflect increasing evidence that its balance sheet reduction is already and increasingly accentuating the tightening of financial conditions, this being very much what the results from its own bank lending survey data (released earlier this week) suggest.
Indeed, banks reported that the ECB reducing its monetary policy asset portfolio both via scaling back APP and the phasing-out of the TLTRO III have both contributed to tighter lending conditions, with a net tightening impact on terms and conditions and a negative impact on bank lending volumes. Moreover, these effects are expected to strengthen over the next six months.
This is consistent with what emerged, in the September Council meeting account. Then, it was argued that the transmission of monetary policy tightening, via prices (loan rates) and quantities (credit volumes) since the first rate hike in July 2022, was both much stronger and faster than expected and where the ECB now describe is as acting forcefully.
Inflation Worries Being Overtaken by Recession Risks?
This seems to be manifesting in recent EZ economic data, particularly regarding real economy prospects, showing ever-clearer softness to a degree that threaten a more formal and fresh recession in H2 this year. Not only in accepting that the labor market is weakening and implicitly acknowledging what may be a more-delayed recovery, the ECB may be getting worried that the downside growth risks it envisages are materializing. Indeed, it is unclear to what degree the ECB Council majority is solely influenced by what we think are more convincing signs of a fall in underlying inflation.
Splits Continuing - Overdoing Tightening
This stable decision may also reflect worries among some Council members about overdoing tightening, concerns that actually appeared in the July Council meeting. Such worries may have been accentuated not only by the continuing acknowledgement that the effects of past rate hikes had not been fully transmitted to the real economy but (as we highlighted above) that the transmission mechanism is working faster than in previous cycles, now also buttressed by rising bond yields. We suggest that this reflects not just the size of hikes but also the unprecedented manner in which banks have raised credit standards much earlier than in previous cycles, and by possibly inter-related adverse impact of the ECB’s balance sheet reduction. Finally, it is worth wondering whether a data dependent approach is valid against a juncture where the ECB seems increasingly concerned that the financial conditions that determine how that data eventually emerges is flashing ever-clearer warning signals.