ECB Preview (Mar 19): No Longer in a Good Place?
With no change in policy expected, what the ECB says is the most important aspect of the ECB meeting next week, both explicitly and implicitly via its updated forecasts (Figure 1). Both are likely to underscore that rate hikes are certainly possible if the almost inevitable inflation rise proves to be either/both significant and/or persistent. But no time frames will be suggested, this papering over what are long-standing splits within the Council regrading policy. There will be some reassurance that market based inflation expectations have risen only modestly and more over the short-term than longer measures (Figure 2). But amid what we think has been ECB complacency and where there will be clear real economy damage from the current conflict and what we see as only a limited and temporary inflation spike, we still regard the next move in rates to be a further cut, though probably only one more 25 bp move later this year.
Figure 1: ECB Projections in Perspective
Source: ECB, Bloomberg, CE, % chg y/y
Like the ECB will do, we have identified four likely scenarios regarding the length and breadth of the Middle East conflict. But under our very much more likely view of limited further fighting we see oil and gas prices largely falling back to the pre-war levels within a year. This will still lead to a clear and fresh rise in inflation, mainly via the direct effects of the HICP measure having a 10% energy weighting but with some second round effects that will affect rates into 2027 (though where actual inflation at the end of next year may be lower than previously thought). This will be on account of the likely real economy damage from the conflict but also reflects our long-standing view that the Council has been complacent, downplaying what we regard are downside risks which may be materialising.
These range from ignoring the fact that a third of what looks to be above trend growth last year was abnormal (due to a surge in Ireland), the U.S. tariff impact and what we think are financial conditions that have actually been tightening even before the impact of the conflict on markets. In fact, banks have not only been tightening credit standards for some months now but are actually refusing to lend to an increasing amount of companies. There is also the Chinese export dumping factor, this likely to depress consumer goods prices and hit GDP via increased EZ imports! These risks are already visible in survey and monetary data.
Figure 2: Inflation Expectations Higher But Limited to Shorter-Term
Source: Bloomberg
All of which convinces us that the ECB will have central forecast more optimistic than ours at least regarding growth – indeed the risk is that the central forecast will essentially be ‘dead on arrival’ if the ECB uses the usual assumption of market pricing some three weeks before the publication. But its likely alternative scenarios may encompass an outlook more in tune with ours, though probably based on more pessimistic energy price assumptions.
Even so, Lagarde faces a challenge with the hawks wanting to send out a very vigilant message and some biased towards hiking in Q2/Q3 if the war persists into April. Even centerists like BdF Villeroy have noted that it is too early to talk about rate hikes, but that the ECB will not allow inflation to take hold. This suggests a two pronged message of stable policy near-term, but ready to act if 2nd round effects threaten. This is not quite a tightening bias, but posturing just in case and Lagarde may underscore that inflation expectations are still under control with any rise largely confined to (usually more volatile) short-term measures. The ECB should also emphasize that the EZ economy is better positioned to absorb shocks, with the current situation very different from that of 2022 and the Ukraine War in which it lost access to Russian gas. Christine Lagarde, said on Tuesday that the ECB will do all that is necessary to keep price increases under control, although it wouldn’t rush into a decision amid so much volatility. This suggests undercurrents of caution on inflation, but not a tightening bias.
Our view is that HICP inflation will peak at just over 2.5% in Q1 next year and that the ECB will be able to see a slowing before that juncture that will allow a further 25 bp rate cut in Q4 that the real and monetary economy may very well be demanding.