ECB Review: ECB Hums Easing Tune for June
Surprising hardly anyone, the ECB is preparing to cut official rates, after what are now five successive stable policy decisions. It explicitly suggested that it could be appropriate to reduce the current level of monetary policy restriction, a policy hint backed up by dropping its previous rhetoric about ‘maintaining’ rates for sufficiently long time. Indeed, there was some dissent from a minority in favor of actual cuts at this juncture. Regardless, the path to a rate cut at the June 6 Council meeting and for some further easing beyond then is thus made clearer, as even a series of rate reduction would still leave policy restrictive. Equally unsurprising, the ECB is reluctant to plan out any particular path, insistent it is, and will remain, ‘data dependent’ most notably on labor costs data. But given existing projections already showing inflation below target by next year (Figure 1) and with downside risks from the likes of the transmission mechanism (Figure 2), the bar is higher for such data to forestall a 25 bp in June. We also feel that neither Fed policy, nor the US$, are likely to delay any ECB move(s).
Figure 1: ECB Sees Inflation Below Target and Durably
Source: ECB
Inflation Undershoot More Likely?
Amid markets reassessing the Fed policy outlook and the ensuing FX repercussions, the question is how such reverberations may affect the ECB outlook. Perspective is needed. Despite the stronger US dollar, the EZ is not getting any competitive gain as the euro effective exchange rate is almost at record highs, partly a result of the weak yen, the net impact adding to tighter EZ financial conditions. At the same time, there is no offset from softer interest rates, the very opposite as EZ market rates above one year out have returned to levels seen at the January ECB Council meeting. This is important as it implies that the updated projections the ECB will produce at the now key June meeting should therefore at the very least echo those offered last month. In fact they may be even softer due a range of factor not least as fiscal policy assumptions may be more restrictive as may financial conditions tighter.
A Possible Rate Cut Path
As is clear, the ECB seems very reluctant to discuss openly any possible rate cut path. But regardless, the very fact that existing ECB forecasts now point to headline inflation below target before and then through 2026 and the core rate at target on the basis of then-market rate pricing of future official rates down to 2.4% next year and through 2026, very much implies a tacit ECB Council endorsement of that rate profile. With this in mind, perhaps the main risk is that interest rates cuts may be larger and/or faster than we have assumed as the monetary policy transmission mechanism proves even more powerful than we have estimated reflecting a grudging and belated acknowledgement that the ECB balance sheet reduction is adding to tighter financial conditions. It is noteworthy that the ECB cites the transmission mechanism as a downside risk to its outlook and this risks continues, if not grows.
Balance Sheet Considerations.
It is ever-clearer that it is the labour market (and particularly labour costs) which are the dominant theme for the ECB is assessing the policy backdrop and outlook – some consideration of profit margins is also be made. But the ECB has been very aware of a still very weak credit and bank deposit backdrop. This was accepted at the March Council meeting where the account noted that a reduced supply of liquidity was also contributing to monetary tightening. Notably, this negative impact from its balance sheet reduction on credit dynamics was very much underscored in the just-released bank lending survey (BLS). Indeed, the BLS was explicit in highlighting that the shrinkage in the ECB monetary policy asset portfolio had a further negative impact on banks’ financing conditions and liquidity position, resulting in a moderate tightening of terms and conditions and a negative effect on lending volumes. This is something we have long argued was occurring and is evident in the unprecedented drop in bank deposits stemming from the ECB balance sheet reduction (Figure 2). This is all the more important as the ECB has no plans (yet) to slow, let alone stop, its unconventional tightening regardless of what and when its reduces official rates. It could be argued that if the ECB purses further balance sheet reduction, then larger/faster conventional easing may be needed!
Figure 2: ECB Balance Sheet Reduction Hurting Deposit Base
Source: ECB
Services Inflation Resilience
While HICP inflation continues to subside amid an economy backdrop which is flat despite some better business surveys, the labor market is still suggesting an easing in labour costs growth. This is particularly in regard to Q4 compensation per employee and to a degree that has surprised the ECB to the downside. Thus should filter through into what has been recent service sector inflation resilience, albeit the latter possibly accentuated by fiscal matters. This service price resilience may be a factor in the ECB hawks remaining vocal, albeit not too loudly or persuasively, but where there may be some highlighting that various underlying price gauges have stopped falling and may even have risen afresh, this also evident in the seasonally adjusted m/m numbers we have been flagging
Policy Outlook
Regardless, we concur with ECB thinking that a good portion of recent disinflation is supply driven but, note with policy hikes still biting, the impact of weak demand will only accentuate this. This is implicitly accepted by the ECB who said last month that ‘a significant part of policy transmission remained in the pipeline, as the coming quarters would see the impact of past policy tightening continuing to be transmitted to bank funding conditions, broader financing conditions, credit volumes and the real economy’. But if the ECB remains focused on the labor costs updates it wants ahead of the June 6 decision, then as such numbers are produced quarterly, then subsequent rate cuts may only arrive in September and December. Hence, our long-standing view that the ECB may cut only some 75 bp this year. However, by year-end more durable evidence of labour costs easing should convince the ECB to continue easing and we see 100 bp further easing through 2025!