ECB Review: Not Such a Good Place!
With no change in policy expected and this being delivered unanimously, the ECB underlined its determination to ensure that inflation stabilises at the 2% target in the medium term. Unsurprisingly, it stressed how the Middle East conflict has made the outlook significantly more uncertain, creating upside risks for inflation and downside risks for economic growth. But is seemed to put more stress on there being a material impact on inflation through higher energy prices in the near-term but the medium-term implications depend both on the intensity and duration of the conflict. It did provide updated forecasts based on market thinking up to Mar 11 which we think are too pessimistic about inflation and too optimistic about growth. But given an updated profile in which its underlying focus on core inflation gradually eases back to target we think market rate hike thinking is very overblown. After all, it has eased policy for some time with the core rate much higher!
Figure 1: ECB Projections Revisions
Source: ECB, Bloomberg, CE, % chg y/y
What the ECB said was always going to be the most important aspect of the Council meeting, both explicitly and implicitly via its updated forecasts. These now see a 0.7 ppt upward revision to HICP inflation this year (to 2.6%) but smaller rises for next year and 2028 but with tilted upside risks. GDP is reined by a cumulative 0.4 ppt but with risks only tilted to the downside. We see this as being optimistic, not least given the fragile nature the economy was on even ahead of the outset of war. Indeed, 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, and where we think the ECB is overstating the likely spill over into core inflation. We still regard the next move in rates to be a further cut. Even if not, we think markets pricing in rate hikes is premature, not least as even the ECB growth optimism still delivers core inflation deviating only slightly from target and still slowing over the forecast horizon.
Indeed, it may be the case that the ECB is still reverberating from the 2022 energy shock and criticism it faced of hiking too slowly. If so, the ECB is getting confused. What is notable is that this energy shock and he ECB’s positioning is very much different to that of 2022, occurring at a point when the EZ economy is operating with a margin of spare capacity as opposed to one reviving from a pandemic induced demand shock. This time around, increases in household fuel and utility costs, and other prices, are more likely to squeeze real incomes and damage already fragile household and business confidence, further weighing on demand. These factors could widen the output gap somewhat, more than potentially constraining second-round effects as should be fact that the current main official rate is currently 2.5 ppt higher than four years ago while HICP inflation is much lower so that ‘real’ rates are very much higher!
However, the ECB has a history of policy mistakes with premature but short-lived hiking (ie 2008 and 2011). Such a risk cannot be ruled out again especially give the Council’s view of the ‘good place’ the EZ economy was in prior to the conflict even if the result of such unjustified action may be to intensify fiscal strains.
Otherwise, the ECB statement had the right balance to avoid fuelling rate hike talk, noting that headline inflation is revised higher (using data to March 11). Combined with the assessment that long-term inflation expectations are well anchored, and the economy has shown resilience, this leaves the impression that the ECB is watchful but maintains a neutral policy rate outlook. Meanwhile, President Lagarde in the Q/A guided that the key is 2nd round effects from higher energy prices suggesting that the ECB is initially inclined to look through the increase in energy prices and not overreact. She also placed emphasis on the duration of the war (long or short) meaning different potential outcomes in energy prices. Lagarde also downplayed questions about how quick the ECB would act, which noted the need to understand the size and duration of energy price changes and the feedthrough into the economy – especially as the economy is less buoyant compared to the 2022 shock, while the natural gas price rose much more than currently. Lagarde also noted that the policy rate is 2% and at a higher starting point than 2022. This all leaves the ECB policy neutral, which could translate into a hike but equally could mean stable policy by mid-year if the Iran war ends and energy prices start to come back down.