ECB sounds more constructive on inflation but we stick to June call

There were a number of elements in the statement that suggested the ECB was becoming more constructive about the inflation outlook. First of all, it removed a caveat about progress with inflation. Whereas in December it noted that ‘underlying inflation has eased further. But domestic price pressures remain elevated, primarily owing to strong growth in unit labour costs’. In January it asserts that ‘the declining trend in underlying inflation has continued, and the past interest rate increases keep being transmitted forcefully into financing conditions. Tight financing conditions are dampening demand, and this is helping to push down inflation’ without any mention of domestic price pressures being problematic. Later in the statement it noted that ‘almost all measures of underlying inflation declined further in December’. In addition, it explained that while ‘elevated rate of wage increases and falling labour productivity are keeping domestic price pressures high’ that ‘these too have started to ease’. Indeed, in the Q&A, President Christine Lagarde also highlighted the Indeed wage tracker (produced by the Central Bank of Ireland), which had clearly peaked and was starting to come down. In addition, ‘lower unit profits have started to moderate the inflationary effect of rising unit labour costs’. Finally, the statement also pointed out that ‘measures of shorter-term inflation expectations have come down markedly, while those of longer-term inflation expectations mostly stand around 2 per cent’. Somewhat surprisingly, the ECB seems to be sticking to a more constructive view on the economic outlook. While admitting that the ‘euro area economy is likely to have stagnated in the final quarter of 2023’ and ‘incoming data continue to signal weakness in the near term’ it took the view that ‘some forward-looking survey indicators point to a pick-up in growth further ahead’. This seems to us to be overplaying some improvements in business surveys, which in our view remain in moderate contraction territory. It would be easy for us to read the ECB’s more constructive commentary on inflation and come to the conclusion that a rate cut was just around the corner. It is particularly tempting given that the ECB’s inflation narrative is coming much closer to our own, with our projections being more optimistic than the central bank’s December update. At the same time, we remain more pessimistic than the ECB on the economic growth outlook. However, we are resisting this temptation and stick to our call for a June rate cut. This is because of the strong concerted effort by officials – including Lagarde – last week to steer market towards a summer rate cut. Indeed, in the Q&A, Lagarde confirmed that she stood behind her comments at Davos. However, we must admit that today’s communication does raise the chances of an earlier move. Looking further out, we think that once the rate cut cycle starts, it is likely to be more extensive than markets currently price, with the deposit rate eventually being reduced to 1.5%. This is because we take the view that the neutral rate remains very low – and likely negative in real terms – meaning that there is a long way down for policy rates just to get out of restrictive territory.