European Central Bank President Christine Lagarde has gone out of her way to translate the ECB’s rather oblique message of “gradualism, optionality, and flexibility” into plain language and explicit interest rate guidance, as she looks to steer expectations ahead of the bank’s first hike in over ten years at its upcoming meeting on July 21.
That includes a telegraphing of the Governing Council’s next two interest rate decisions in the clearest of terms in a speech at the ECB Forum which I was delighted to attend last week in Sintra, Portugal.
Here is Lagarde, in her own words, on the next two meetings:
[We] intend to raise our three key interest rates by 25 basis points at our next meeting on 21 July. But we also announced that we expect to raise the key interest rates again in September, and “if the medium-term inflation outlook persists or deteriorates, a larger increment will be appropriate at the September meeting.”
As she subsequently explained, and we paraphrase here, that means the first hike will be “gradual,” after which the ECB will exercise its “optionality” to be, well, let’s call it less gradual.
For ECB watchers, that part of the June 28 opening speech in Sintra simply reinforced a policy message that Lagarde had already delivered both in a May 23 blog, and in a subsequent press conference after the June 9 Governing Council meeting.
But in repeating that message, Lagarde preempted a growing number of Council members clamoring for a more aggressive hike in July, while in effect again all but promising an acceleration to 50 basis points at the next meeting.
The key to keeping that consensus is that the inflation outlook and pressures need merely to “persist” to stick to that promised 50 bp accelerated pace. With the last staff forecasts in June looking for inflation to drop from 6.8% this year to 3.5% in 2023, and just 2.1% in 2024, it is hard to see that bar failing to be met in September – barring a real recession.
Stated differently, it is the 25-basis point lift-off that under the current outlook is an anomaly.
For markets that have been aggressively ahead of the ECB on rate hike expectations, it is, however, those very recession fears that have now wiped 75 basis points from peak to trough off 2022 rate hike expectations over the past two weeks.
The ECB is clearly also concerned about an impending slowdown, driven by the increasing likelihood of an energy crunch in the winter of this year. But they have not penciled in a recession.
Labor markets are historically strong, savings are high, and consumption, particularly of services, has held up remarkably well. Wage growth appears to be headed to 4% this year and next, even as more cautious ECB officials note that job security tends to be a larger factor in determining European wage negotiations than in the United States.
That strong economy can of course turn quickly, and on the employment front many ECB officials point to, for example, the various national government-subsidized pandemic employment programs that will soon be rolling off. More dramatically, the ECB chief economist and staff predict that four percentage points could be lopped off eurozone GDP in the case of a severe gas shutoff this winter.
The challenge however for traders who are now wiping rate hikes off the table over recession fears is that energy supply cuts are of course also highly inflationary, and the ECB already has a serious, imminent, and spreading inflation problem at hand, even as it is likely to significantly mark growth down from its June estimates.
Perhaps most important of all is the long-term evidence that, in Lagarde’s own words, after 25 years of an “heroic” fight against disinflation, the global central banks are facing a “new regime” in which the cost of dealing with the retrenchment of a high-inflation regime is unacceptably high.
To riff off the popular Game of Thrones, “winter is coming,” but the ECB will unfortunately have to hike rates through the slowdown.
And so, with recession fears mounting in markets, what once was a tempered ECB message to markets is, ironically, now hawkish to expectations.
Front-loading, Pricing, and Distance
Indeed, one argument for front loading in 2022 even in the expectation of an impending slowdown is that the early parts of this rate hike cycle are, if anything, the easy ones.
That includes an argument that it is increasingly hard to explain a 25 bp increment for lift-off now that the severe market anxiety over Italian bond yield spreads – much of it we feel exaggerated, if not “a story looking for a crisis” — has largely dissipated, at least for now, and will be soon managed with the roll out by the ECB of an important anti-fragmentation backstop tool. The framework for that backstop is hoped to be in place by the meeting on July 21, even if perhaps not yet completely agreed to and finalized.
That said, prudence dictates that it is never a good tactic to rain on one’s own parade with lift-off. However, as Lagarde noted in Sintra, having an anti-fragmentation backstop in place will make it that much easier for the ECB to subsequently do what it needs to do.
And so, while changing consensus for July, though possible, is a heavy lift, we do believe 50 bp hikes are quite possible, if not likely, to follow from September into Q4 of 2022.
To cut to the chase, we believe markets should price for a very minimum of 125 bps in hikes over the next four meetings of this year, a minimum sequence we would think of as 25+50+25+25, with a high likelihood that one or more of those latter 25s will be 50 bps.
Starting at a -0.5% deposit rate, even 150 bps of rate hikes would mean the ECB will have only begun to scratch the very bottom of the broad, and still yet undefined, roughly 1-2% nominal neutral rate band over the course of half a year.
With inflation still pressing to the upside, this gap, and timing, matters.
Inflation in a 19-Member Zone
When asked in a Q+A session at Sintra about the just released 10% headline inflation numbers in Spain, Lagarde counseled patience, to wait for the release of German inflation numbers (pushed lower by subsidized 9-euro train fares), and for the release of the full Eurozone June estimates that Friday.
Those numbers are in, and they will have done little to ease the frustration and concerns of many officials in the ECB Governing Council.
Core CPI in June is estimated to have come in one tenth of a percent lower than the previous month, at 3.7%, while headline inflation popped up to an eye catching 8.6%, on the back of still soaring energy prices.
The pass through of these energy prices is of course the single biggest determinant of the variability in HICP inflation between euro zone member states. High energy prices have already spread deeply into other sectors, most notably food prices, with fully 4 out of 5 components in the Eurostat’s HICP basket now rising at a pace higher than the ECB’s 2% inflation target.
So as a simple exercise to gauge the politics of inflation and the real pressures faced by individual member states (and presumably their national central banks), we looked at the median inflation rate for the euro area when ranked by country.
Of the 19 member states, 14 experienced inflation rates higher than the 8.6% eurozone aggregate, with the “national median” so to speak falling to the Netherlands at 9.9%, just below Spain’s 10.0%.
Only two countries, France, (where energy inflation has been aggressively contained by fiscal subsidies), and Malta, registered inflation under 8%.
A Riveting Presentation on Gas
The direction of travel of course is what ultimately matters, and more important than any single variable for the eurozone economy is energy supply and in particular, natural gas.
And here, one of the most eye-opening of the many excellent presentations at Sintra was a sober and clinical assessment of the near- and medium-term outlook for gas supply and demand that was made by Christian Zinglersen, Director of the EU’s ACER (Agency for the Cooperation of Energy Regulators).
While worth a read in its entirety, our non-expert takeaways included an assessment that for the EU to meet its target of 80% natural gas storage capacity by November 1, and eventually wean off Russia as planned, it would require a diversion of 10% of the world’s LNG supplies to the EU. That does not factor in the specter of a protracted squeeze – now widely expected by European officials – of the current “maintenance” shutdowns of gas pipelines from Russia.
Furthermore, you may add us to the long list of skeptics on the proposal by the Biden administration to form a buyer’s cartel against Russia to drive oil prices down.
That, if anything, reflects Washington’s unease at the already negotiated and agreed oil restrictions by the EU, an unease that we suspect may manifest itself when push comes to shove in a case of “alligator arms” when it comes to delivering those promised US LNG supplies to the EU.
Regardless, having subsidized high energy prices to the consumer for months, an economically dubious strategy with inflation roaring, even if a social necessity, the EU is likely to need to impose constraints on demand as well this winter.
Winter is, indeed, coming.