The implications of the ECB’s pivot

Modest rise in the depo rate from the end of this year, but close call whether window closes before then

ECB President Christine Lagarde’s signalling of a more speedy wind down of the APP and earlier depo rate hike came as a surprise to us last Thursday. The ECB’s pivot seems to have been based largely on the upward surprise in the preliminary HICP data for January. Although energy prices remained the key driver of the inflation surprise, the core rate did not decline as much as expected, which may have supported the view that underlying inflation was starting to firm. In addition, the ECB seems to be becoming more confident that wage growth will rise this year, on the basis of its own survey of employers as well as positive unemployment surprises.

Despite this ex-post rationalisation, the pivot is difficult to really justify based on the ECB’s previous stance and communication. The acceleration of inflation we have seen this year is not linked to sizzling demand but rather to supply-side shocks beyond the control of the ECB. These shocks are not only pushing up inflation, but are weighing on domestic demand, not least because they diminish the purchasing power of households. All other things being equal, these shocks tend to boost inflation in year one, but reduce it in year two.

This is the case as long as there are no second round effects, which is the case so far. Wage growth remains muted. For instance, growth of negotiated wages is running at around 1.5%, while a level of 3% is consistent with the ECB’s target. So an acceleration of wage growth from these levels would need to be extremely sharp to be problematic. In the absence of second round effects, it makes no sense for central banks to react to supply side shocks by tightening monetary policy. Indeed, the ECB President herself said that this would be ‘exactly the wrong thing to do’ just a few months ago.

Despite our difficulty in justifying policy tightening, it is clear from Ms. Lagarde’s remarks that the ECB is heading for the exit. In March, the Governing Council will likely announce a tapering of the APP, with net purchases ending altogether in September. We expect APP to average EUR 30bn in Q2 and EUR 15bn in Q3. We have also pencilled in a 10bp deposit rate hike in December of this year and an additional one in March of next year. After that we expect rate hikes to be aborted, or at least put on ice, with the deposit rate at -0.3% by the end of 2023.

The window of opportunity for hikes may close

So essentially, we are predicting somewhat of a false start for policy normalisation. Indeed, we think it is a close call whether by the end of this year the window of ‘opportunity’ for rate hikes may close. This reflects a number of considerations. Firstly, inflation will very likely be coming down sharply by the end of this year, and could even be below target around the time the ECB pulls the trigger. Second, economic growth is likely to come in below current ECB expectations this year, and will slow further next year. Third, aggressive Fed tightening this year will likely tighten eurozone financial conditions. Finally, there is the possibility of continued upward pressure on peripheral spreads. The ECB will in the first instance fight that by skewing reinvestments towards these jurisdictions. However, if that proves not be enough, net asset purchases will need to resume and given the sequencing of exit (net purchases need to end before rate hikes begin), this could also be a reason to delay rate hikes.