ECB to try and dampen inflation expectations and euro decline

Our previous more cautious scenario was based on two key elements. Firstly, economic growth is likely to significantly undershoot the ECB’s projections this year. Secondly, given high rates of inflation appear to be mostly supply-driven, it is unclear what ECB rate hikes would really achieve, apart from adding to the headwinds facing the economy. Although we maintain the conviction in both cases, we judge that the situation has changed in recent weeks in a number of important respects. First, the hawkish shift in the Governing Council has become more extreme, with even usually dovish members now sounding more concerned about inflation.

This is probably related to a second – and crucial – development. Inflation expectations have been on the rise and the ECB is becoming concerned that they might become dislodged. The ECB Survey of Professional Forecasters now shows an average expectation of inflation of 2.1% over the long-term. Meanwhile, expectations implied by market measures – which are more up to date – have continued their upward trend over recent days, with the 5y5y inflation swap at 2.4%. The ECB pays close attention to these measures as they point to a risk that the current high inflation could become entrenched if it impacts price and wage setting behaviour. It must be noted that there is little sign of this at the moment, with wage growth very subdued, but the Governing Council wants to manage this risk.

A final development that will trigger early ECB action is the decline in the euro. This decline could accelerate if the ECB falls too far behind other major central banks in raising interest rates. A weaker euro pushes up inflation directly by raising import prices. Given that the current high inflation rate is mainly imported (surging prices of energy, other commodities and manufactured goods) a much weaker euro would extenuate these trends.

A period on hold after zero

After the deposit rate reaches zero at the end of this year, we expect policy rates to subsequently remain on hold for a period. This reflects that we expect a second round of headwinds to be hitting the economy in 2023. This year’s weakness is mainly driven by the energy price shock. Next year’s will likely reflect the feed through of tighter monetary policy globally as well as less of a buffer from fiscal policy and excess savings. Economic growth is likely to be sub-trend during 2023. An additional reason to expect the ECB to take a break is that headline inflation will likely be on the way down and likely fall sharply early in 2023, as the impact of past rises in energy prices dissipates. This should also bring down inflation expectations, which we judge to be reactive to actual inflation developments (formed via an adaptive process) rather that being particularly forward looking. Finally, we think that supply side improvements in the labour market have brought down the equilibrium rate of unemployment (the so-called NAIRU) and therefore wage growth will not be a threat to the ECB’s inflation goal, especially against the background of weak economic activity. (Nick Kounis & Aline Schuiling)