We would suggest you put any “on the one hand, on the other hand” summary of the just released minutes of the March 10 European Central Bank meeting of the Governing Council safely in your “read later” inbox. They were, in a nutshell, unmitigatedly hawkish.
Indeed, in years of covering major central banks, we find it hard to recall a set of minutes like these, revealing in great depth deliberations and a wholesale challenge and rejection by the ECB’s key policy makers of their chief economist and staff’s continually overly optimistic, dovish, and unrealistic Covid-era inflation forecasts.
Faced with soaring inflation, energy costs, and war risks, and with critical real-time monetary policy decisions lying ahead, one must commend the ECB for that level of transparency and debate in its minutes (see, at the time, SGH 3/10/22, “ECB: Strong Decision, Weak Forecasts”). It is, furthermore, hard to imagine anything would have softened the hawkish case since.
In brief, for markets, we have included what we feel were the most important lines out of the unusually detailed, 11,319-word minutes below. They confirm to us not only that the Asset Purchase Program is coming to a speedy conclusion, but that the Governing Council is, for all its deliberate ambiguity on rate hikes, ready for liftoff on rates soon after the end of APP. Very soon.
To be more granular, here were our expectations going into today’s read of the March minutes:
In SGH 4/4/22, “ECB: The Adverse Inflation Scenario,” we wrote that a broad consensus had been building around the Governing Council for an end to APP bond purchases in July that will, after the August recess, be likely followed by a first 25 bp rate hike in September and a second 25 bp rate hike in December, to bring the currently negative 0.50% deposit rate to zero before year-end.
We also wrote that with realized inflation continuing to top all the ECB staff expectations, and likely to do so for some more months ahead at least, there was a real chance this still forming consensus and sequencing could be brought forward by roughly two months.
That would mean ending APP in June to open the door for lift-off in July, followed by a second interest rate hike in September or October. Today’s minutes, and our read of the internal ECB deliberations, if anything adds to our sense that the ECB may end up seeking greater optionality and taking this more accelerated path.
We are skeptical, however, that the ECB, facing considerable uncertainty over the war in Ukraine, would go so far as to follow the Fed’s lead with a more dramatic 50 basis point hike to get out of negative rates in one shot, as has been floated in markets recently. Even the Fed opened its rate hiking cycle with a 25-basis points hike.
As to the minutes, here are what we believe to be some particularly relevant and interesting excerpts (our underlining in parts for emphasis):
On this basis it was argued that, for all practical purposes, the three forward guidance conditions for an upward adjustment of the key ECB interest rates had either already been met or were very close to being met.
Again, on liftoff:
The significant further fall in real interest rates to record low levels and the depreciation of the euro suggested that the monetary policy stance remained very accommodative. This raised the question of whether the configuration of monetary policy instruments, including the negative interest rate policy, was still consistent with inflation returning to target over the medium term.
A large number of members held the view that the current high level of inflation and its persistence called for immediate further steps towards monetary policy normalisation.
Regarding perma-doves and the staff forecasts:
The greater persistence of inflation increased the probability of second-round effects via strengthening wage dynamics. While wage growth had remained moderate so far, it usually reacted with a lag and possibly in a non-linear way, with the heightened risk of a wage-price spiral if monetary policy did not act in a timely manner. Moreover, a longer period of above-target inflation would lead to an increased risk of an upward unanchoring of longer-term inflation expectations. The latest measures of market-based inflation compensation had moved above 2% along the entire maturity structure for the first time in many years. In such circumstances, the Governing Council could no longer afford to look through higher inflation, even if it was driven by an adverse supply shock.
Trashing the staff baseline, and medium-term forecasts:
In their discussion of the March 2022 staff projections, members noted the substantial upward revision to the short-term inflation outlook since the December 2021 projections. February’s inflation data release was the latest in a string of consecutive upside surprises. This had led to the largest revisions to inflation projections in many years, both in December and again in March. The high levels of inflation had thus turned out to be less transitory than previously expected, while the latest ECB staff projections nonetheless still foresaw a rapid decline in inflation, nearly to target, over the projection horizon. Sizeable and persistent projection errors for core inflation were also seen as a reminder that the models were underestimating the impact of the recovery and the pass-through of input prices to final consumer prices.
In particular, doubts were expressed about the convergence of inflation to 1.9% as expected in the baseline staff projection for 2024, the last year of the projection horizon. The question was raised as to how one could expect such a fast mean reversion in inflation, faster than in the previous projection round, after the current huge shocks to inflation. It appeared puzzling that inflation projections would still fall somewhat short of the 2% target in 2024 despite consecutive upside surprises in inflation outcomes, a persistently positive output gap for most of the projection horizon and the latest increases in longer-term inflation expectations.
Regarding wage pressures:
In any case, inflation, which was stubbornly high and higher than expected, was widely seen as increasing the likelihood that there would be second-round effects, which in turn would make higher inflation more persistent. It was argued that, if second-round effects in wages were to emerge, these could last longer than a year, as wage contracts tended to be concluded for longer periods. Concerns were expressed that second-round effects might well be of a non-linear nature, taking some time to emerge but then becoming very strong and difficult to stop. Labour market dynamics and indications of increasing labour market tightness were seen to point clearly to rising wage pressures in the period ahead. It was argued that in the past the impact of energy price increases had been short-lived and had therefore been more naturally absorbed by wages or profit margins. This time the situation appeared to be different, however, given the large energy shock in conjunction with far-reaching structural changes, post-pandemic pent-up demand and supply shortages. This called into question the seemingly very muted reaction of wages to inflation in the staff projections.
More challenges, and time to get moving:
With respect to the medium-term outlook, it was considered that the projection for food price inflation might be on the low side towards the end of the horizon and the question was raised whether it could be higher for longer. Reference was also made to the likely upward impact on medium-term inflation projections of developments in the costs of owner-occupied housing, which were not yet part of the official HICP index. In view of these different considerations, it was argued that there should be no pretence of knowing what the exact number for inflation would be in 2024, while more attention could be given to uncertainty and risk distributions around point estimates for inflation.