ECB Sin(a)tra Preview: Should the ECB Only Consider My Way?

ECB Sin(a)tra Preview: Should the ECB Only Consider My Way?

The speed and manner in which the ECB adopted a hawkish stance is response to the Middle East conflict was no surprise; it has many precedents, some of which have led to policy errors which we think may be being repeated at this juncture.  Indeed, despite friendlier price and costs signals, the ECB has chosen to adhere to the upside prices risks that only some data have been flagging.  But the ECB may have to reassess in the not to distant future given what we believe will be in the June HICP flash (Wed), which may drop markedly, thereby suggesting that headline inflation has already passed its peak and maybe clearly and widely so. These data may have a material impact on ECB thinking, especially as the data arrive toward the end of the ECB monetary annual gathering in Sintra (Mon-Wed).

Figure 1: June Headline To Plunge And Core to Ease Modestly Too?

Source: Eurostat, CE

Even given what seem to be a series of reassuring aspects, the May flash HICP data is unlikely to have a material impact on ECB thinking.  After all, headline HICP rose just 0.2 ppt to 3.2%, still a 32-mth high, but where softer food prices and stable non-energy goods helped temper what were higher services inflation (up 0.5 ppt to a six-mth high of 3.5%).  This latter increase was obviously unwelcome and reverberated among the ECB hawks whose talons now dominate the Council to a degree where the rate hike this month became all but nailed on. 

Indeed, the way numbers for June are mounting up suggests the headline rate peaked at 3.2% in May and not the 3.4% rate implicit for June in the ECB quarterly projections released earlier this month.  In fact, we see the headline down to as low as 2.7% pulled down not just by hefty energy price falls but also an unwind to a seasonal aberration in travel prices that pushed up services inflation in May. This could involve small dip in the core too (Figure 1).

Indeed as for June, marked falls in fuel prices have clearly occurred on the back of the oil price slide – gas prices have fallen too, albeit never likely to have anything like a similar bearing on the inflation outlook.  Regardless the ECB still suggests it is too early to reassess the current oil price situation, even given the clear falls in petrol and diesel prices (Figure 2).  In fact, ECB comments seem to still regard risks biased to the upside.  This is despite what was a second successive friendlier price and cost message from the PMI data, which did note further signs of inflationary pressures easing in June. Although input costs continued to rise rapidly during the month, the rate of inflation eased to the slowest since February, just before the outbreak of war in the Middle East. Weaker increases in input prices were seen across both the manufacturing and service sectors, with the pace of inflation remaining sharper in the former. In turn, the rate of output price inflation also slowed in June, albeit to a lesser extent than was seen for input costs. Here too, manufacturers continued to record stronger inflation than their services counterparts.

While tilted to the upside, this produces risks on both sides but those possibly precipitating second-round effects, we note the marked contrast in the labor market and consumer price expectations compared to the inflation surge that followed the invasion of Ukraine four years ago.  Of course, and as survey have highlighted cost rising fast, but nowhere near as much as seen in 2022.

Figure 2: Retail Fuel Prices Plunging

Source: European Commission

Regardless, and arguing against any clear wage spiral emergence, an ever-wider array of survey data suggest also that job losses are also starting to become worryingly widespread as business confidence in any swift turnaround in the adverse economic climate fades further.  Notably, the service sector is being hit especially hard by the cost surges created by the war. Moreover, what is even more notable is that supply shortages not only pose upside risks to prices but can and seem to be constraining real activity already growth already and probably more so in the coming months but also have the potential to add further upward pressure to inflation. 

But the ECB is seeing a clear and wider price shock.  It has been using so-called Quantile Regression Forests, an advanced machine learning and AI tool integrated into the ECB’s forecasting toolkit. It is used to generate real-time, short-term inflation projections and to "nowcast" GDP growth and its latest result suggest a core rate rising to 3% before year end, almost a full ppt above that projected in March.  Even so, actual HICP data are still showing no such signs, and neither are short-term HICP components – the very opposite (Figure 3)! But the ECB is more mindful of its credibility and it does look that after the one hike in June, the question is if another will follow soon after!

Figure 3: Core Short-Term HICP Messages Still Benign

Source: Eurostat, CE

In fact, the Sintra gathering (Jun 29- Jul1) may see the ECB very much endorse the alleged rationale behind its June hike, this forgetting the very optimistic GDP assumption for 2026 that all the scenarios that backed the more were based on.  The more vocal hawks at the ECB remain focused on seemingly still apparent resilient services inflation but now are allowing the energy price surge to perturb them further.  Of course, the ECB is still reverberating from the energy-induced surge in inflation that ensued from the pandemic and then the Ukraine War and the criticism levied at it about being slow to react.  But perspective is needed as it is important to stress that the EZ economy is better positioned to absorb shocks, with the current situation very different from that of Feb 2022 and the Ukraine War in which in losing access to Russian gas was a ‘shock’ super-imposed on an EZ economy where demand was recovering from the pandemic the latter having caused clear shortages.

This will be partly on account of the likely real economy damage from the conflict but also reflects our long-standing view that the ECB has been complacent, downplaying what we regard are downside real economy and monetary risks which may now be materialising and possibly more intensely given the manner in which financial conditions have tightened. 

Notably, banks have not only been tightening credit standards for some months now but are actually refusing to lend to an increasing amount of companies and are now raising effective rates to customers, this making the next ECB bank lending survey (2 days before the next Council meeting on Jul 23) all the more important.  This raises the question about credit availability because the Council tightened even before it considers what it should to the price of credit (Ie interest rates) as much upon the price.

To us, HICP inflation has peaked and may average around the June outcome for the rest of the year (ie some 0.75 ppt below ECB current projections.  Moreover, as long as the Straits of Hormuz stay open ties the ECB’s policy hands.  In fact we still see the June hike being more that reversed into 2027.