No policy decision is expected at the Monetary Policy Meeting of the Governing Council of the European Central Bank that concludes this coming Thursday, February 3, and which falls between its quarterly staff forecast revision rounds. What is likely to come out of the meeting are, in the words of one official, “some small communications shifts.”
The underlying impulse across the risk-averse Governing Council remains one of patience, and of still adding additional accommodation through a slowly decelerating Asset Purchase Program through the course of 2022.
To be more precise, the ECB expects to end its Asset Purchase Program by the end of 2022, to be likely followed with a rate hike and liftoff from its -0.5% deposit rate in the very beginning of 2023. This expectation for liftoff in Q1 of 2023, which is about one quarter later than market expectations, remains the ECB base case, and will be communicated as such.
But inflation data has of course continued to come in higher than the ECB expected – officials are braced for “a few more” 4-5% range numbers – and even if inflation is still widely expected by ECB officials to be “more or less” close to a peak, that peak was initially expected to come last November.
Having jacked up their 2022 inflation forecasts already last December, these continued elevated inflation readings may not move the needle much for 2022 when the ECB reassesses at its next quarterly review on March 10. At least that is the current thinking.
But for the more critical policy horizon, the ECB will raise its 1.8% inflation forecast in March for 2023 and 2024, already a whisker away from the ECB’s 2% target (more on this below), and ECB communications are already hinting at this shift. That will finally create room for the start to the discussion of a normalization cycle from the still deeply negative policy interest rates.
With that in mind, and continued upside pressure on 2022, it is hard to see markets removing the optionality of a Q4 end to the APP program and a late Q4 rate hike, or for ECB officials to definitively rule that out, even as they continue to stick to their base case scenario. Conversely, under the ECB’s guidance and reaction function it is hard to envision a hike earlier than that, unless the inflation data goes seriously awry.
More Upwards Revisions to Inflation
You will recall that there were already considerable doubts, in the words of one official, among “many members” of the Governing Council surrounding the December 16 meeting inflation forecasts that was presented by Chief Economist Philip Lane (see SGH 12/15/21, “ECB: Limited Commitment and Guidance”).
In those forecasts, while marking inflation considerably higher for 2022, from a 1.7% forecast in September to 3.2% in December, the largest revision on record for the ECB, Lane kept expectations for inflation through 2023 and 2024 at 1.8%, just below the critical 2% policy target.
Underpinning that expectation, as stressed repeatedly by ECB President Christine Lagarde, were ECB models that saw energy prices reverting to some lower modal level, the oft cited rolling off German VAT and statistical base effects, and the hoped for second half 2022 relief from supply side constraint pressures.
Most importantly, however, the ECB models also assumed powerful structural forces that for the past two decades have pulled underlying inflation around, if not frustratingly below, the 2% level.
But energy prices, in particular natural gas prices, have not just skyrocketed across the Eurozone, but remain stubbornly high, and are increasingly hard to simply “look through.” These elevated prices we are told are feeding through for example into fertilizer costs, which in turn fuel elevated food prices that could go on into next year. Perhaps even more importantly, they are also feeding into consumer price expectations.
Similarly, ECB officials appear less willing to completely look through what have been skyrocketing, and continued elevated, raw materials prices.
In the past, Euro area retail chains wielded considerable clout in dictating prices and absorbing temporary spikes in raw material prices. But in the words of one official, that is now “more or less over,” and the higher costs are being passed through to consumers. This official goes as far as to say the long period of too low inflation is now over, and the Eurozone is already back in the cycle of “regular inflation.”
Finally, most officials agree that one important place where inflation is not manifesting is in wages.
But even here, the wage numbers usually cited are old, aggregate data is still lagging, and it is hard to imagine that wage demands are not drifting higher.
And while there is clearly no sign of a “wage-price spiral,” a bit of a straw man argument as that would clearly be a signal of being already dangerously behind the proverbial curve on inflation, real wages are in fact going down, eroded by inflation, and hurting the lowest rungs of the socioeconomic class.
Communications with the Public and Markets
Turning back to ECB policy and guidance, when the Governing Council laid out its sequencing and bond program normalization guidance last December, there was a good deal of consternation among hawkish members of the Council that the central bank had tied its hands too much on asset purchases, for a full year, on rate hikes that can only follow when the APP is completed, and on the reinvestment of maturing pandemic program bonds through “at least 2024.”
Having said that, since then ECB officials have been quite disciplined in sticking with a reasonably united framework and message, even as upside risks have continued to mount. We suspect the real discussions, and divisions, over exit policy will not manifest until deeper into 2022.
In the meantime, when questioned about the rationale for the ECB to continue pumping additional stimulus into the system with its bond purchase program, even if at a slower pace, sources point to the need now to offset the drop off in fiscal stimulus across the Eurozone, roughly by half from the pandemic levels of 2021, and an expected drop further in 2023 once the 3% Stability and Growth Pact deficit/GDP limits kick back in.
While this may be a sound economic argument, it is an awkward one to make politically with the Covid crisis increasingly in the rearview mirror, given the EU Treaty restrictions on the central bank financing of government debt. More to the point, it will continue to be a challenge to explain the ECB policy path to a public concerned about inflationary pressures here and now.