27 Apr 2023
European Macro Recap and Outlook.
Following the ECB meeting and March's banking sector turbulence, the conversation among policymakers is evolving - focusing on May's data-driven decision rather than the all-out need for a rate hike.
You might have assumed that after the latest ECB meeting and the rollercoaster ride of March's banking sector, it was time to step back, take a breather, and perhaps even disconnect for a while, right? Well you guessed wrong. The tone among policymakers has shifted from an unconditional need to hike interest rates to a more nuanced, data-dependent approach for May's decision. This change in stance is hardly shocking as inflation seems to be cooling off.
The final March Eurozone inflation figures reveal a drop in headline inflation to +6.9% YoY (from +8.5%), while core inflation climbs another 0.1pp to +5.7%. This dip in MoM core is the first in a year but can be easily explained. March's dip in MoM core is easily explainable: it usually sees high repricing action. But the larger-than-usual repricing in January likely reduced the need for repricing in March. This one-time effect is unlikely to repeat in April, so brace yourselves for the ECB's core inflation expectation of +4.6% for the year to be challenged. The March repricing effect was most apparent in clothing, where the underperformance correlates strongly with the larger repricing in January. This historical relationship has seen larger movements since the GFC
Right now, the primary concern is underlying inflation. Numerous ECB members have cited it as a concern or a factor necessitating a pause.
Its being rumoured that core inflation should stabilize above +5.5% YoY in the next few months. April's preliminary data, due at the start of May, will likely confirm that the ECB's projections are too low. Even with soaring food prices, energy prices could drag headline inflation lower. Barring a new energy price crisis, this will likely result in a near-term headline undershoot of ECB forecasts.
Considering Lagarde's focus, persistent tightness in labor markets, and increased attention on corporate profits, this should be a net-hawkish outcome – even more so if high underlying inflation feeds into inflation expectations. It seems highly probable that May's hike could be the last 50bps hike. I've previously mentioned the possibility of the ECB hiking above 4%; I now shift my base case to a 4% terminal rate.
Right now, a 50bp hike in May is my base case. If core inflation will remains above the ECB forecast, then the ECB will need top hike with 50 bps. ECB President Christine Lagarde’s recent speeches reaffirm the emphasis on underlying inflation instead. In her recent speech Lagarde mentioned that inflation in the Euro area went down from its highest point in October, mainly because energy prices dropped. This drop happened due to a few reasons, such as lower basic costs, cheaper energy resources, and government actions to protect people from high energy costs. However, food and other basic inflation rates kept going up. This happened because of higher energy and other costs from the past that still affect consumer prices. When the economy reopened, there was more demand for products, and supply problems continued to push prices higher. At the same time, workers asked for more money because their purchasing power was lower in tight job markets. This led to higher wages, and many companies facing limited supply and more demand increased their profits.
I think inflation in the Euro area will keep going down as old price pressures go away and stricter financial policies reduce demand. However, high wage growth, which comes from tight job markets and the need to make up for high inflation, will help keep core inflation steady until it reaches the 2% goal . This forecast has a lot of uncertainty, and there are both positive and negative risks. Inflation could go up if pressures in the supply chain are stronger than expected, or if wages or profits increase more than expected. On the other hand, issues in financial markets and lower energy prices could make inflation go down faster. Currently, most predictions for long-term inflation are around two per cent, but we need to keep watching them.
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