ECB: The “Adverse” Inflation Scenario

Published on April 4, 2022
SGH Insight
...When the ECB Governing Council meets for its monetary policy meeting on Thursday, April 14, our understanding is that its number one goal will therefore be to communicate that it is taking inflation seriously.
President Christine Lagarde, as a lawyer by training, will point to the ECB’s inflation mandate and stress the importance of institutional credibility. On the policy front, we believe Lagarde will indicate that a concrete decision to end the Asset Purchase Program, barring some enormous unforeseen development, will come at the next meeting in June.
ECB officials note that while communications after the March meeting have indicated the possibility of an accelerated end to the ECB’s bond buying Asset Purchase Program in the third quarter of 2022, that “in” does not mean the end of the quarter, “as some had interpreted,” but could also mean the beginning, in July...


...ECB officials note that while communications after the March meeting have indicated the possibility of an accelerated end to the ECB’s bond buying Asset Purchase Program in the third quarter of 2022, that “in” does not mean the end of the quarter, “as some had interpreted,” but could also mean the beginning, in July.
The consensus timeframe many ECB officials are now seemingly zeroing in on is a decision to end the APP on June 9, a cessation in July, a first 25 basis points hike at the September 8 quarterly review meeting, followed by a second 25 basis points rate hike at the next quarterly review meeting on December 15.
That more or less quarterly sequencing and pace would bring the ECB deposit rate from -0.50% to zero before the end of the year. Understanding that monetary policy acts with a lag, and that none of these decisions will come in time to impact 2022 inflation, ECB officials will present this as a “normalization” of policy to better position for 2023 and 2024, rather than an outright “tightening” of rates.
Having said that, we expect ECB officials will find it increasingly challenging to explain the logic behind an eight month “normalization” process as it revises its near-term forecasts yet higher and faces a public that is increasingly battered by inflationary pressures, retailers that are scrambling to adjust to higher commodity and input prices, and wages that continue to lag.
We suspect there is therefore an outside chance that rate hike sequence could be brought forward by two months...
Market Validation
ECB Press Conference April 14th
*Lagarde: Bond Buys "Very Likely" To End In 3Q, Could Be Early or Could Be Late
*LAGARDE: `SOME TIME AFTER' CAN MEAN A WEEK OR SEVERAL MONTHS


ECB Minutes April 7th:

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. Inflation was projected to be far above target in 2022, with unprecedented upward revisions over the latest two projection rounds. It was projected to remain above target in 2023, with significant upside risks, as also evidenced by the alternative scenarios. Moreover, it was argued that the baseline inflation projection for 2024 could be assessed to be already effectively on target, when the heightened uncertainty surrounding the outlook and the fragility of the assumptions underlying the projections were taken into account. In addition, available measures of underlying inflation had moved above 2%, suggesting that the staff projections may be underestimating the persistence of above-target inflation.
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.

The ink had not even dried on the European Central Bank’s last quarterly forecast revision on March 10, and it was already clear to all but the most dovish of ECB officials that the upwardly revised “baseline” inflation scenario that had been just laid out by Chief Economist Philip Lane was unlikely to pan out (see SGH 3/10/22, “ECB: Strong Decision, Weak Forecast”).

Indeed, in the words of one ECB official, the Eurozone is now clearly heading if not already well into Lane’s “adverse” scenario, where 2022 inflation would be marked up from 5.1% to 5.9%, and 2022 GDP down from 3.7% to 2.5%.

But even that adjustment for an “adverse” scenario would understate the inflation pressures visible on the horizon, as well as the potential downside pressures to Eurozone growth from the war in Ukraine and high energy prices.

Indeed, with inflation already rising at an uncomfortable pace before Russia’s invasion of Ukraine, and an enormous caveat over the course of the war and energy prices, some ECB officials now expect annual 2022 inflation could end up somewhere in the 7% range. 

They note that even before the latest eye-popping 7.5% Eurozone March CPI estimate release, for example, the Netherlands, Europe’s 5th largest economy, had registered a 7.3% inflation rate in February, followed by 11.9% in March. Expectations in the ECB are mounting of potentially one or two more months of double-digit inflation across the Eurozone.

Eurozone Harmonized Inflation 2016 – Present:

A 2% revision upwards in inflation would, incidentally, fall under Lane’s “severe” scenario.

When the ECB Governing Council meets for its monetary policy meeting on Thursday, April 14, our understanding is that its number one goal will therefore be to communicate that it is taking inflation seriously.

President Christine Lagarde, as a lawyer by training, will point to the ECB’s inflation mandate and stress the importance of institutional credibility. On the policy front, we believe Lagarde will indicate that a concrete decision to end the Asset Purchase Program, barring some enormous unforeseen development, will come at the next meeting in June.

ECB officials note that while communications after the March meeting have indicated the possibility of an accelerated end to the ECB’s bond buying Asset Purchase Program in the third quarter of 2022, that “in” does not mean the end of the quarter, “as some had interpreted,” but could also mean the beginning, in July.

The consensus timeframe many ECB officials are now seemingly zeroing in on is a decision to end the APP on June 9, a cessation in July, a first 25 basis points hike at the September 8 quarterly review meeting, followed by a second 25 basis points rate hike at the next quarterly review meeting on December 15.

That more or less quarterly sequencing and pace would bring the ECB deposit rate from -0.50% to zero before the end of the year. Understanding that monetary policy acts with a lag, and that none of these decisions will come in time to impact 2022 inflation, ECB officials will present this as a “normalization” of policy to better position for 2023 and 2024, rather than an outright “tightening” of rates.

Having said that, we expect ECB officials will find it increasingly challenging to explain the logic behind an eight month “normalization” process as it revises its near-term forecasts yet higher and faces a public that is increasingly battered by inflationary pressures, retailers that are scrambling to adjust to higher commodity and input prices, and wages that continue to lag. 

We suspect there is therefore an outside chance that rate hike sequence could be brought forward by two months.

That means markets should keep an open mind to the possibility of a surprise consensus to form at next week’s meeting to end the APP in June, which would open the door to hikes in the July and October meetings, even though that does not seem to be where ECB consensus lies at this time.

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