• ECB’s hawkish tone surprises markets
• Comments and changed guidance do give additional flexibility but…
• …Economic impacts of invasion of Ukraine currently seen aggravating already surging inflation rather than undermining solid economic growth
• So, Asset Purchase Programme now set to end sooner than previously signaled …
• … and rates still likely to rise late in 2022
• Inflation moving to target from above implies different risks for ECB and markets to a path to target from below      

Analysis by Austin Hughes

While the ECB has given itself some increased flexibility to adapt its policy path in response to economic and financial fallout from the Russian invasion of Ukraine, the key message from today’s ECB Governing Council meeting was one of growing concern about a larger and longer-lasting uplift in inflation and persistent upside risks to that outlook.

In turn, this prompted fairly clear indications from Frankfurt today that the ECB is now on course to end its bond purchase scheme sooner than previously indicated and, accordingly, remains likely to begin raising policy rates before the end of this year.

ECB president, Christine Lagarde, strongly argued that the changes in guidance presented today were intended to give the ECB additional ‘optionality’ in an uncertain environment. However, the specific adjustments to the end of the Asset Purchase Programme, coupled with the tougher tone in comments in relation to inflation concerns signal a further shift to a notably more ‘hawkish’ stance than most in the market had expected.

These surprise developments compounded the significant volatility in financial markets of recent days. For this reason, there was a marked increase in market interest rates and an associated strengthening of the exchange rate of the Euro.

Ukraine an important issue but inflation concerns remain paramount

Not surprisingly, today’s ECB statement began by acknowledging the ‘watershed’ nature of events in Ukraine and went on to express ‘its full support for the people of Ukraine’ as well as promising to ensure smooth liquidity conditions and implement EU sanctions. It might have been expected that these elements would stand alone in the statement.  

However, importantly, in the same opening paragraph, the ECB emphasised its commitment to ‘take whatever action is needed to fulfil the ECB’s mandate to pursue price stability and to safeguard financial stability’.  This phrasing recalling Draghi’s famous ‘whatever it takes’ commitment suggests that current ECB concerns about elevated inflation will not be set aside unless there is an altogether more dramatic deterioration in the outlook for the Euro area economy.   

While ECB president, Christine Lagarde, spoke of ‘different views around the table in all directions’ both the tone of the press statement and the changes in the ECB’S new projections from the estimates of three months ago suggest the ECB is altogether more concerned about the manner in which events in Ukraine threaten to materially worsen an already worrisome inflation outlook more than it might weaken a softer but still broadly positive outlook for growth.

Faster end to Asset Purchase scheme underlines increased hawkish tone 

Although ECB president, Christine Lagarde, repeatedly referred to a ‘balanced’ approach in relation to today’s ECB decisions. A clearly more hawkish element is a faster proposed ending of the current Asset Purchase programme.

The ECB previously indicated that it would purchase € 40 billion each month in the second quarter,  € 30 billion each month in the third quarter, and, following that €20 billion monthly ‘for as long as necessary’.

Today the ECB indicated it would purchase ‘€ 40 billion in April, €30 billion in May and €20 billion in June’. Thereafter, 'The calibration of net purchases for the third quarter will be data-dependent …. If the incoming data support the expectation that the medium-term inflation outlook will not weaken even after the end of our net asset purchases, the Governing Council will conclude net purchases under the APP in the third quarter’.

In principle, today’s statement that ‘The calibration of net purchases for the third quarter will be data-dependent and reflect our evolving assessment of the outlook’ means that the ECB has  significant wriggle room in terms of the future timing and speed of policy changes. However, the central path defined today is one of an earlier and more abrupt end to net asset purchases than the ECB had previously set out.

'Optionality' may not always lie in the same direction 

In the same vein, Mme Lagarde repeatedly highlighted the scope for a variety of future time-paths for policy and the particular capacity to respond to unexpected downside risks provided by the statement that ‘if the medium-term inflation outlook changes and if financing conditions become inconsistent with further progress towards our two per cent target, we stand ready to revise our schedule for net asset purchases in terms of size and/or duration’.

A much stronger presentation of the same defense was offered by Mme Lagarde when she highlighted a notable change in terms of the ECB roadmap from previous guidance that ‘The Governing Council expects net purchases to end shortly before it starts raising the key ECB interest rates’ to today’s altogether less specific indication ‘Any adjustments to the key ECB interest rates will take place some time after the end of the Governing Council’s net purchases under the APP and will be gradual.’.

Significantly, the promise that rate increases when they arrive will be ‘gradual’ is a notable concession but as indicated in other parts of the policy statement, that commitment is heavily conditional in that it is ‘data dependent’.

Mechanically, the assertion in today’s altered guidance that policy rates should rise ‘some time’ rather than ‘shortly’ after the end of net asset purchases is likely intended to suggest a longer gap between the now earlier intended end of net asset purchase and the first lift-off in policy rates but it may offer less comfort than appears to be the case.

First of all, not to have altered this element today would have implied an earlier hike in light of the changed timing of the end of net asset purchases. Second, ‘some time’  could. in extremis, also be interpreted as immediately after rather than longer after, and finally, the fact that guidance can change suddenly and unexpectedly means that current commitments are not set in stone.

Importantly, the ECB sees the conditions needed to begin normalising policy as falling into place at present. First of all , today’s statement notes that ‘The Governing Council sees it as increasingly likely that inflation will stabilise at its two per cent target over the medium term’. As the diagram below illustrates, an altogether changed environment now means that the ECB sees its inflation target being realised through a gradual slowing of inflation rather than the repeatedly unrealised projection of rising inflation seen in ECB projections for many years.

Second, reflecting this  changed environment, the three conditions the ECB has repeatedly set out for the start of normalisation are clearly met in that inflation is now above 2% and set to remain at or above 2% ‘well ahead of the end of our projection horizon’, thereby meeting the first and second conditions and finally, as today’s statement notes  ‘Price rises have become more widespread. Most measures of underlying inflation have risen over recent months to levels above two per cent.’

Even though the statement continues ‘However, it is uncertain how persistent the rise in these indicators will be, today’s new  projections show inflation excluding food and energy at 2.6% this year, 1.8% in 2023 and 1.9% in 2024. This implies ‘realised progress in underlying inflation..’ is ‘..consistent with our inflation target.’.

Flexibility and fear

Today’s ECB comments and changed guidance clearly give the ECB increased flexibility about its policy path through the remainder of the year but in circumstances where Mme Lagarde emphasised its ‘data dependency’, as well as reiterating near term upside inflation risks, there is a clear possibility that the timing for ‘normalisation’ moves forward rather than backward in the next couple of months.

Indeed, should such upside risks to prices start to encompass a pick-up in wages, there are clear risks that we move beyond a path to normalisation to a notably faster and clearly less ‘gradual’ path of policy tightening. The risks around a path to the inflation target approached from above are clearly different in terms of market outcomes to a path approached from below.