Last week's pronouncements designed to ensure ECB retains ‘optionality’ but suggest it is on course for early tightening

• No major change in thinking since meeting of five weeks earlier
• Initial ‘dovish’ interpretation of comments may reflect ‘hawkish’ market thinking
• ECB remains concerned about downside risks to growth ….
• … but upside risks to inflation still the key focus..
• … So upcoming ‘core’ inflation data may indicate how fast and how far tightening goes in 2022  

Analysis by Austin Hughes

The ECB finds itself in an almost impossible situation at present. One paragraph in the opening press statement following last Thursday's ECB Governing Council began by noting ‘The downside risks to the growth outlook have increased substantially as a result of the war in Ukraine’. The next paragraph began ‘The upside risks surrounding the inflation outlook have also intensified, especially in the near term.’

The broad message from last week's Governing Council meeting is that the ECB is clearly set on a path-indeed, ECB president, Christine Lagarde, noted ‘the journey has begun’, towards ‘normalising’ policy and although the ECB president didn’t specify time or amounts, it seems clear more than one interest rate increase will be implemented before end-year.

Indeed, a ‘sources’ story that appeared on newswires shortly after the meeting concluded suggested there was a growing consensus on an initial rate hike by September, with some council members indicating a move as early as July was possible.

However, how far and how fast any tightening may go is still unclear as the ECB, perhaps understandably, looks to determine how large and long-lasting both the upward pressure on inflation and the downside threat to growth may prove to be. The ECB sought to carve out wriggle room by emphasising ‘ In the current conditions of high uncertainty, we will maintain optionality, gradualism and flexibility in the conduct of monetary policy.’

By repeatedly emphasising the previously announced sequencing of policy adjustment, whereby the first stage encompassing the end of the ECB’s Asset Purchase Programme would ‘take place some time after the end of our net purchases under the APP’, the ECB is seeking to prevent markets from further ramping up expectations that ECB rates might rise early and often.

However, to maintain a measure of flexibility to move sooner if judged necessary, Mme Lagarde added that the end of Asset Purchases ‘could be earlier or later’ during the third quarter and ‘some time’  could be ‘anywhere between a week and several months’.     

While upcoming data could tilt the balance towards a faster or slower pace of normalisation, to the extent that there was any surprise in the latest press conference, markets deemed that the ECB pronouncements struck a slightly more dovish tone after what was seen to be an unexpectedly hawkish tilt at the previous Governing Council in March (although in combination with increased expectations for aggressive US policy tightening, term rates rose in the Euro area while the exchange rate of the Euro slipped against the dollar).

Although it may seem to be splitting hairs, rather than judging last Thursday's meeting to be dovish or hawkish, the key takeaway is that the ECB didn’t further ramp up the hawkish twist evident in March. In circumstances, where the US Federal Reserve has stepped up its hawkish signalling of late and both the Reserve Bank of New Zealand and the Bank of Canada shifted from 25 to 50 basis points increases last week, many in the market felt the ECB would further accelerate the move to a first rate hike.

Instead, the ECB has prioritised ‘optionality’, allowing it to speed up or slow down the path to policy normalisation in the next couple of months. Mme Lagarde emphasised the importance of the June round of ECB projections to the scale and speed of future ECB tightening and the press statement continues to emphasise that future policy adjustments will be ‘data dependent’. In that context, a number of elements of last week's press statement suggest that just five weeks on from the previous meeting, the ECB has not markedly altered its view of current developments in relation to growth prospects and price pressures.

While the ECB acknowledged in March that growth this year would be slower than previously expected, it had indicated that ‘the euro area economy should still grow robustly in 2022’. In contrast, the latest comment notes ‘Several factors point to slow growth also in the period ahead’. Similarly, on inflation the ECB repeated the view that energy costs ‘continue to be the main reason for the high rate of inflation.’ Thursday's comment added ‘Market-based indicators suggest that energy prices will stay high in the near term but will then moderate to some extent.’ The statement also continues to see wage increases as ‘muted’.

If it is not surprising that the ECB has not dramatically altered its thinking in the past five weeks, it should also be clear that this means it sees itself five weeks closer to tightening. It is also the case that circumstances could change markedly in what could be a long eight weeks before the next Governing Council meeting. In that regard, a key issue will be the extent to which surprises in upcoming data are more pronounced in relation to upside outturns in relation to core inflation or downside surprises in regard to economic activity.

I think that while risks to Euro area growth from a major conflict on the region’s borders may be material, these may take time to emerge. In isolation, this would suggest the case to ‘hasten slowly’. 

A more immediate influence may be the profile of core inflation in coming months. As the diagram below illustrates, the trajectory of ‘core’ inflation in the Euro area has been notably less explosive than that in the US, and when adjusted to a two-year annualised rate to remove pandemic related effects (dark blue line below) has only moved to a pace consistent with ECB policy goals at the start of this year.

 
The diagram suggests US price pressures emerged in a pronounced manner around six months before those in the Euro area. On the very simplistic view that the policy response might followed a similar pattern, that would suggest an initial ECB rate hike in September. However, in light of a widespread view that the Fed was too slow to start tightening, this would leave open the possibility of an ECB move as early as July.  

One potentially important swing factor may be the trend in core inflation in coming months. Although Easter effects could distort the April consumer price reading towards the upside, the figure for May might provide some better indication as to whether price pressures are broadening or still relatively contained. As a result, the scale and speed of ECB tightening through the second half of 2022 could be significantly influenced by the preliminary inflation reading for May which will be released on May 31st.