ECB January Council Meeting Account Review: Clearer Need to Assess Market Rates Thinking
Unsurprisingly, the account of the January 24-25 ECB Council meeting was interesting is anticipating some downward revision to growth and inflation projections at the looming Mar 7 meeting. Moreover, it was noted that market rate thinking was in part an endogenous reaction and thus needed to be carefully assessed – in other words market rate thinking reflected a different (and possibly more valid) trajectory for both inflation and real growth. While the discussion also very much focused on the importance of wage developments and possible labor hoarding in assessing the inflation outlook, it also noted that wages are far from the while story in this regard. As for inflation, it was seen to have fallen faster and perhaps more broadly both on an underlying and price persistence basis (Figure 1). While the account regarded it premature to discuss easing, this was only by consensus, implying a minority wanted such a debate. This is not surprising given the manner in which important data is both highlighting an ever clearer disinflation process and underscoring the manner in which policy tightening is still to bite anywhere near fully. The debate next month may be much more biased towards a very clear easing discussion.
Figure 1: Persistent Price Pressures Ebbing
Source: ECB - Persistent and Common Component of Inflation (PCCI)
Momentum in Inflation Falling
It was noted that while domestic inflation remained high at 4.5%, owing to the elevated pace of wage increases and falling labour productivity, it too had started to ease. Indicators of momentum in headline inflation and all of its components had eased further. The annualized three-month-on-three-month growth rate of seasonally adjusted core inflation had fallen below 1.5% (The ECB seems to be using shorter-term price measures more frequently now). A broad range of underlying inflation measures had also fallen into December. Among the different measures, It was noted that the Persistent and Common Component of Inflation was the best predictor of inflation one and two years ahead and had eased to 2% in December – NB; it has fallen below 2% into 2024 and broadly so (Figure 1). There was a also a recognition that, historically, the Purchasing Managers’ Indices for prices had not been able to capture developments in goods and services inflation very well – this being important given the upward pressures the latest such surveys have hinted at! But it was accepted that both headline and underlying inflation figures had recently been continuously below the predicted levels, suggesting a faster than anticipated disinflationary process. It was therefore likely that in March, with the new projections, there would be a downward revision to inflation for 2024. In this context, it was highlighted that the staff projections tended to underestimate changes in inflation momentum in both directions.
Recovery Postponed?
As for the economy, it was widely acknowledged that growth would likely be weaker than expected in the short term. So far, however, the decline in inflation was coming at a relatively mild cost in terms of economic activity. On the one hand, survey indicators suggested that the economy might have bottomed out given less negative PMI indicators but it was still thought that the next staff projections would most likely shift the start of the recovery by one or two quarters again. For the new staff projections, the prevailing market expectations regarding interest rates were also important as conditioning assumptions. Market expectations were seen to significantly lower than those underlying the December projections. Since the lower path for interest rates currently expected by markets was in part an endogenous reaction to which lower nominal rates would translate into higher growth and inflation in the future needed to be carefully assessed – in other words market rate thinking reflected a different trajectory for both inflation and real growth. This should include looking at how the expected path of real rates would change in the projections with new assumptions.
Labor Hoarding Explains Record Low Jobless Rate?
In regard to the labor market, conditions there were seen as persistently very tight, something we regard as being misplaced given the extent to which labor supply has jumped and companies may have been hoarding labor. Nevertheless, it was argued (and has been repeated openly since) that the Governing Council would need to see some hard data confirming that wages had turned the corner. At the same time, it was highlighted that the labour market was clearly showing signs of cooling, and that was likely to have a dampening effect on future wage growth. Given that significant labour hoarding had occurred, either economic activity would have to recover soon or employment and wage growth had to fall and we think there are already signs of the latter materializing, not least an already-visible decline in job vacancies.
But wages may not be the whole story as it was accepted that inflation could be falling in spite of increasing wage, not least as the latter amounted to only around 40% of firms’ total costs and most indicators of intermediate costs were currently falling. With this mind, it was suggested that now that intermediate costs and profit margins were moving in the opposite direction to wages, wage growth was not a sufficient indicator to capture overall cost pressures in the economy, something we concluded in a recent article!