Headline inflation is coming down thanks to base effects, and officials are admitting that even if financial market jitters calm down, fears of financial dislocation are likely to have a disinflationary effect. Core inflation remains far too high though.
Unless bank stress escalates, the ECB is likely to slow the pace of rate increases, but not halt the tightening cycle in May.
At first glance the ECB’s economic bulletin today was pretty much as expected. The editorial repeated that inflation has been too high for too long, and this is pretty much what Lagarde said at the press conference. However, while that was a justification to go ahead with the 50 basis point rate hike despite market tensions, officials are now starting to take into account the impact of financial market jitters on the outlook for growth and inflation.
The staff projections were finalized before bank angst escalated, and at the last meeting Lagarde mainly focused on heightened uncertainty against the background of market tensions. She subsequently went on record warning that “if, for example, banks start to apply a larger ‘intermediation wedge’ -– meaning that at any level of the base rate they demand a higher compensation for the perceived risk they are taking on when lending -– then pass-through (of rate hikes) will become stronger,” which would imply that it could cut short the ECB’s tightening cycle.
The editorial in the economic bulletin also added downside risks to the inflation assessment that were notably absent in Lagarde’s last introductory statement. Specifically, it said that “the downside risks to inflation include persistently elevated financial market tensions that could accelerate disinflation. In addition, falling energy prices could translate into reduced pressure from underlying inflation and wages. A weakening of demand, including owing to a stronger deceleration of bank credit or a stronger than projected transmission of monetary policy, would also contribute to lower price pressures than currently anticipated, especially over the medium term.”
The central scenario still remains that financial market tensions are likely to abate gradually. And even ECB chief economist Lane, hardly a hawk, flagged that “if the financial stress we see is non-zero, but turns out to be still fairly limited, interest rates will still need to go up”. Lane added, however, that “if the financial stress we talked about becomes stronger, then we will have to see what is appropriate”. “If this financial stress weakens the economy, it would automatically reduce the inflationary pressures”.
ECB’s Schnabel, Executive Board member responsible for markets, still seems cautiously optimistic that things won’t get out of hand. However, even Schnabel, who reportedly wanted the ECB to maintain an official tightening bias at the last meeting, admitted that the region could still see some tightening of credit conditions.
“Directionally it is very clear this would have a disinflationary effect that we would need to take into account”.
This marks an admission that even from the hawks there could be negative effects . With the bulletin flagging possible downside risks to inflation, while also saying that the risks to the economic outlook are tilted to the downside, the ECB seems to be paving the way for a slowdown in tightening moves, while keeping the door open for a pause if things get out of hand.
The dovish camp is already very eager to stop any further hikes from going ahead, and they will get further ammunition from the March inflation numbers due tomorrow. Data from Spain and Germany showed significant drops in headline rates as base effects from the initial impact of Russia’s invasion of Ukraine fell out of the equation.
ECB dove Stournaras may be sticking to the line that the ECB’s target is the headline rate, not core inflation, but it is clear that the majority of council members are now more worried about the stickiness of core readings. Indeed, Vice President de Guindos made very clear recently that core inflation needs to go down significantly before the ECB can declare victory over inflation.
An ECB blog-post warned that “tit-for-tat” inflation dynamics, where both firms and workers try to offset any real income losses, could create “risks of an upward spiral that could make everyone poorer”.
BoE Governor Bailey sent a similar message this week. But, after several years of wage restraint and with food price inflation in double digits, wage negations are particularly tough this year. Economic activity in Q1 will be capped by widespread strike action on both sides of the Channel.
For central banks it is a difficult situation, as there is no sign that underlying inflation pressures are really coming down. On the other hand, even in the best-case-scenarios financial market jitters are likely to leave their mark. In the central scenario we expect the ECB to continue to hike rates next month, but at a slower pace with a switch to 25 basis point moves, and without a commitment to additional steps. This looks to be the most likely outcome for May.
Until then, the evolution of bank deposits, but also bank lending, will be in focus as markets and ECB officials try to gauge the impact of financial market jitters.
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Andria Pichidi
Market Analyst
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