ECB Preview: Evidence of Forceful Transmission Mechanism to Keep ECB Holding
Bottom Line: The cumulative and sizeable rate hikes at each of the ten previous Council meeting informally ended with the deposit rate left at 4.0% at the last Council meeting in October. That (very much expected) decision was unanimous and we think both the vote and outcome will be repeated when the next ECB Council verdict is given on Dec14. But there are several areas of interest still. First, to what degree may the (somewhat optimistic) ECB economic projections (Figure 1) be amended and to a degree that the envisaged drop inflation to below target is brought forward from the current Q4 2025 schedule. Second, whether the sharp and (to some) surprise drop in inflation (to below ECB thinking) is seen to be an aberration or something more fundamental. And while there may be some suggestion the ECB needs to address bank's excess liquidity, markets may be keener to see if any changes to the outlook are on the cards, most specifically an early end to PEPP reinvestments.
Figure 1: ECB Too Optimistic on Growth
Source: Bloomberg, ECB, CE
How Long is “Sufficiently Long”
The widely expected stable policy decision next week would still leave official rates at the highest in ECB history and encompassing a cumulative hike of 450 bp, also unprecedented and taking a toll on both demand and most measures of underlying inflation. Against this backdrop it unsurprising that the ECB has already effectively diluted any tightening bias.President Lagarde is again likely to use the press conference to underline policy is now 'holding' but underline no early easing. However, she will be quizzed that if the Council really does have a predisposition that it will be data dependent, then how much more downside surprises will be need to make the ECB at least implicitly accept it has not only hiked extensively but also excessively. Indeed, given current ECB thinking which states that 'we consider that rates are at levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to our target', the question is actually how long is “sufficiently long” and what will persuade the ECB that such a period of time has been reached.
First Glimpse of 2026
It could be argued that such a point has already been reached given that existing ECB projections envisage inflation below target by Q4 2025.This makes the scale and direction of revisions to the overall package of forecasts all the more interesting. Almost certainly the ECB will revise back its 2024 thinking for 2024 GDP (Figure 1).But any such a downgrade may be small and possibly even offset by an upgrade to the 2025 outlook, all on the basis of the large fall in market interest rates seen in the last few months. As a result, it is entirely possible (but maybe not plausible) that the ECB's 2025 inflation projection will not change materially. In addition to which the ECB will unveil its first glimpse for the economy in 2026 and could very easily project inflation at or above target regard whatever they imply what 2025 may herald.
No PEPP Talk
Last time around, Lagarde underlined that 'neither the PEPP, nor the remuneration of required reserves have been discussed. The issue of remuneration of required reserves is almost certainly linked to ECB concerns about commercial bank's excess liquidity and whether raising reserve requirements may help address this - it would only have modest effects. Instead, reducing its balance sheet may be a more effective way if addressing excess liquidity and this may be why several Council members have raised the possibility of an early end to PEPP reinvestments. The problem here is twofold. First, the current directive suggests no end to PEPP reinvestments until at least the end of 2024. In other words the perceived risk was that ending reinvestments was more likely to come after the end of 2024 and not before. Thus, going back on such a clear and biased directive may damage ECB credibility ahead. Secondly, the ECB must be aware that conventional policy easing is on the cards for 2024. It would have a possible communication conflict if, in coming months, it started to accept rate cuts are possible whilst not only continuing to tighten unconventionally but actually stepping up the pace of QT .Maybe this is why the ECB has been so keen to suggest policy easing discussion is premature. At most, the ECB may suggest it will create a committee to discuss the matter.
Policy Considerations
It is notable not only by the manner in which the Council has now swung fully in favor of stable policy, but is more clearly accepting that the transmission mechanism is working faster and more strongly than in previous cycles. Indeed, the latter was described as acting forcefully with the October Q&A and even acknowledging ensuing risks to financial stability. It is the transmission mechanism's ever-clearer power that persuades us 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 mid-2024. This already looking all the more likely given the manner in which inflation this quarter is likely to undershot ECB projections for the both the headline and core figures. In addition, so-called persistent price pressures have fallen (Figure 2). All of which persuades us that the ECB has indeed presided over an extensive tightening but also an excessive one! As a result, rate cuts may start before mid-2024.
Figure 2: Persistent Price Pressures Slowing Sharply
Source: ECB, PCCI=Persistent and Common Component of Inflation