SGH Insight
Where the ECB will need to firm up its communications is in why the ratcheting up of rate hike expectations, as this stepped-up hawkishness is coming at a time when they are finally seeing some glimmers of hope in the ever elusive “peak inflation” narrative. Otherwise, we suspect, markets, and indeed many governors, will continue to misread data, inflation risks, and even mislead on the ECB reaction function.
That headline inflation relief is from nose-bleed levels and driven largely by energy prices finally coming off, but it is some relief, nevertheless. ECB officials have indeed been looking for inflation to come down around the first quarter of this year, and markets will understandably be cheered to see any confirmation of continued signs that it is, indeed, finally coming down.
But markets would be well advised against leaning too much on that narrative, as they tried to do after last November’s CPI reports. This “Phase Two” of the ECB tightening cycle, a markedly more hawkish reaction function than many in the markets or even across the Council itself were hoping for, is, as we have been writing repeatedly, entirely about shaking out the dreaded and far more problematic, underlying, core inflationary pressures that have been creeping up.
This bears repeating: “Phase Two,” if we want to call it that, is all about hitting underlying inflationary pressures.
The hawks at the ECB, including notably Isabel Schnabel at the Executive Board, have been warning about these pressures now for months, and their materialization is now coming through in spades — even in the Chief Economist’s staff economic forecast.
Market Validation
Bloomberg 1/9/23
European Central Bank Chief Economist Philip Lane said price pressures in the euro area will remain elevated even if surging energy costs are starting to ease.
“This is not conclusive for the overall inflation dynamic,” Lane told a panel discussion in New Orleans. The original energy shock resulting from Russia’s war in Ukraine and pandemic reopening effects will feed into wages “for the next two or three years,” he said.
Euro-area inflation slowed to 9.2% in December, more than economists had predicted, according to data released Friday. The slowdown was driven by energy, though a measure of price growth that strips out such volatile items reached a record 5.2%.
With wage increases so far falling short of these price gains, there’s now a gap that will “keep pressure on inflation for the next number of years,” Lane said.
Still, if the slowdown in energy costs persists, it should over time feed into “less pressure on food inflation, less pressure on core inflation,” Lane said. “We should recognize that but, of course, we also should recognize the uncertainty about the future path of energy prices.”
The ECB raised borrowing costs by 250 basis points last year and pledged that more hikes will follow. Simulations show that the current level of interest rates isn’t enough to return inflation to the 2% target in a timely manner, Lane said.
Bloomberg 1/9/23
The European Central Bank predicts wage
growth — a key indicator of where inflation is headed — will be
“very strong” in the coming quarters, strengthening the case for
more interest-rate hikes.
A study of salary developments since the start of the
pandemic shows underlying pay growth has been “relatively
moderate” and is currently close to its long-term trend, the
institution said Monday in an article to be published in its
Economic Bulletin.
Even so, “looking ahead, wage growth over the next few
quarters is expected to be very strong compared with historical
patterns,” it said. “This reflects robust labor markets that so
far haven’t been substantially affected by the slowing of the
economy, increases in national minimum wages and some catch-up
between wages and high rates of inflation.”
