European Macro Recap & Outlook

European Macro Recap & Outlook

The ECB's recent meetings have given us an insight into their thought process on monetary policy. The central bank is committed to maintaining price stability, which is crucial for the long-term health of the euro zone's economy and its member states.

Inflation only goes up in Europe.

We are back listening to Christine Lagarde, and the rest of her gang speak about how the Eurozone is doing just fine with their current monetary policy. It's like watching a clown juggling balls, except for its interest rates and inflation targets instead of balls. And let's remember the occasional pie in the face when they have to explain interest rates. They should hire a circus act for their next press conference - at least then, we'd have something entertaining to watch while they talk about inflation.

There was a slight decline in headline inflation mixed with a jump in core inflation, which is certainly not what the ECB had wanted. The increase in food inflation stands out, jumping from 14.1 to 15% in February. Services inflation is also an apparent worry, increasing from 4.4 to 4.8%. With wage growth on the rise, there are concerns that services inflation could prove sticky at high levels. To make matters worse, energy inflation did not drop in line with market price developments, thanks partly to French changes in the tariff shield.

The silver lining is that the core inflation increases were mainly due to base effects and using their seasonal adjustment. The ECB found that the monthly rise in core prices was slightly down from January. So not as alarming as it looks at first sight. However, at 0.5% month-on-month, core inflation is still growing at an annualized pace above 6%, which is nowhere near the ECB's target.


So, how bad is this exactly?

The February reading is an apparent setback, but forward-looking indicators show that the declining trend in inflation is set to continue. March will offer a much faster drop in headline inflation as the massive jump from last March falls out of the year-on-year comparison. Energy inflation is predicted to turn negative soon. But the question is how fast other price categories will see declines?

While producer prices for food are showing smaller increases and outright declines in food commodity prices, which should lead to slower consumer food inflation over the year, goods inflation is also set to fade in the months ahead as input costs have improved markedly and selling price expectations from manufacturers are falling quickly. The big worry is services inflation, as faster wage growth could sticky services inflation.

Still, the smaller-than-expected decline in inflation in February is essential, as the ECB takes current underlying inflation seriously as a factor for determining policy. At the same time, it is also important to put less emphasis on this one figure. A rate hike at the March ECB meeting is more or less a given at 50 basis points, and May is still quite some time away.

There is a clear risk of the ECB having to do more. Still, ECB Chief Economist Philip Lane indicated earlier this week that a lot is pointing in the right direction for inflation to come under control. The difference between disappointing current inflation and optimism about forward-looking indicators will likely bring more debate between hawks and doves ahead of the post-March meetings. Before May, they will have quite some data to judge whether February was a blip or if inflation remains stickier than expected.


A tightening Monetary Policy

The ECB intends to continue raising interest rates beyond the March meeting. In a recent session, the ECB revealed that they would be raising rates past March. They have also let their monetary stance for the coming months be known.

The ECB is currently hawkish and stems from the risk of higher wage growth and sticky inflation, along with limited evidence of stabilization . However, not all ECB members agreed on this point. There was a lengthy discussion on whether there was too much focus on core inflation.

The discussion on the terminal rate remained uncertain. Concerns of overtightening were generally felt premature, given the high inflation levels and the likely persistence of underlying price pressures. It was also emphasized that policy rates needed to be more consistent with the range of estimates for the neutral rate.

Interestingly, the ECB tried to downplay the current pace of monetary policy tightening, calling it a necessary normalization to address high inflation rather than a severe squeeze on banks or their customers.

The Outlook

Looking ahead, the macroeconomic background is expected to remain stable. However, the downward revision of German GDP growth in the fourth quarter suggests that the eurozone may not have avoided a recession. Despite the improved confidence indicators, weak current assessments and high inventory buildup preclude too much optimism.

The ECB will release fresh staff forecasts, considering the sharp drop in energy prices and the increase in bond yields compared to the December forecasts. Regardless of the new staff projections, the 50bps hike in March is likely.

The ECB’s main concern is that what started as supply-driven inflation could morph into demand-driven inflation. Beyond the March meeting, the ECB may face a new game where further rate hikes may not get the same support from the governing council, as hiking deep into restrictive territory increases the risk of adverse economic effects.

The ECB is expected to stop its back-and-forth on forward guidance at the March meeting and shift towards a fundamental meeting-by-meeting approach. The main question beyond the March meeting is whether the ECB will wait to see the impact of its tightening on the economy or continue hiking until core inflation significantly drops.

Between March and the next meeting in May, crucial data releases such as tentative first-quarter GDP growth data will be available. GDP growth is an essential piece of evidence that could tilt the balance in either direction, either continue hiking rates until actual inflation comes down or prepare to pause to assess the impact of rate hikes so far.

A compromise may be reached, with two additional rate hikes of 25 bp each in May and June before pausing the hiking cycle and entering a more extended wait-and-see period. This would bring ECB rates close to historic highs. The next few weeks are crucial for the ECB. The upcoming inflation data will show if the previous data was affected by seasonality or if inflation is sticker than anticipated. If it is stickier than anticipated, they will hike further into June. If not, rates could be paused starting in June.

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