The European Central Bank celebrates this Thursday the penultimate monetary conclave of the year. A ‘warm-up’ meeting, according to some analysts, to face the final jump in December, when the institution will have to tie the end of the purchase program against the pandemic (PEPP, for its acronym in English) and give more clues about the future interest rates. However, this meeting can be a bit dangerous, as it comes amid rising inflationary pressures, with the entire monetary arsenal still in place and with an economy full of bottlenecks that are unleashing long-term inflation expectations in the euro zone. The ECB will have to justify its policy while convincing the market that inflation will not deviate for long.
The gap between official ECB interest rates and inflation is historic. Never before in the short history of the euro have real interest rates been in such negative territory (interest rates minus inflation). Real interest rates are currently close to -4%, reflecting an extremely expansionary monetary policy coupled with prices that seem to have awakened after years of slumber.
This combination, which is tolerable in the countries of southern Europe (the most indebted) , is very annoying in the ‘hawks’ of the north and center (net creditors), who also fear that the rise in inflation is only the beginning of something worse.
“What appeared to be a rather boring ECB policy meeting might turn out to be more interesting than initially thought . High inflation, higher debt interest rates and weakening growth prospects mean that the combination of data is complicated for the ECB, “says Dirk Schumacher, strategist at Natixis.
The difference between inflation and the deposit facility rate is historical
The controversy is served. The ECB, especially its President Christine Lagarde, will have to argue better than ever why a monetary turn of the tiller is not necessary when an inflationary storm looms on the horizon. Oliver Rakau, an economist at Oxford Economics, notes in a note that no changes are expected at the October ECB meeting, as key policy decisions are closely linked to the macroeconomic projections to be released in December. However, this week’s meeting will clearly set the tone, as the controversial debate on inflation prospects will intensify in the Governing Council. ”
Not an easy job
This expert believes that rising prices are making the ECB’s job much harder. “This work has become more difficult in recent months in the context of a sharp increase in inflation rates in the Eurozone and around the world. Central banks in emerging markets have already started to raise official rates. Also there are central banks in advanced economies that seem to be about to begin to harden their stance in the face of inflation risks in the medium term, such as the Bank of England. ”
The ECB can argue its cautious attitude about the mistakes that were “the premature rate hikes in 2009 and 2011, so now they want to avoid making the same mistake”
Long-term inflation expectations have exceeded 2% in the euro zone , which would be precisely consistent with the objective of the European Central Bank, which is to bring the general CPI to this rate of change on a sustained basis. The problem is that the trend is clear and only shows one direction: up. Headline CPI stands at 3.4% in the euro zone and is forecast to reach 4% this year, which could continue to fuel inflation expectations in the euro zone.
From ING they believe that it is not only the real inflation data that have been higher than the ECB expected. “Higher energy prices and a weaker euro exchange rate than the latest macroeconomic projections will also give the ECB headaches.” All this increases the pressure on a central bank that planned to keep interest rates at minimums for years. Now, “the markets have even begun to bet on a first rate hike by the ECB as early as 2022 , two years earlier than we and the market consensus predict,” says Rakau.
An exercise in conviction
Lagarde has an important mission: to maintain the credibility of the institution. To do this, it must convince the markets that inflation is still transitory, something that is not entirely clear right now, and lower expectations of rate hikes: “The market is well ahead of the likely response from the ECB,” says Giles. Gale, Head of Strategy for Europe at NatWest Markets. “Lagarde will have to remind the market that they are serious enough about their future orientation and that this path does not lead to a high inflation scenario.”
Guiding investors will be a key challenge for Lagarde. If inflation is here to stay longer, the market may be waiting for some kind of change in the ECB’s roadmap. Simply put, if the factors surrounding the economy change, the central bank should readjust its policy or at least its future orientation.
The inactivity of a central bank in the face of inflation that remains below target can erode agents’ confidence in highly respected institutions in the developed world.
The ECB’s arguments
In addition, this Friday the CPI of the euro zone is expected to grow close to 4%, double what the ECB intends to achieve in the medium term.
The ECB can argue that much of this inflation is imported, since it comes from a boom in international prices for energy, metals or food. In this case, a tighter monetary policy would not be as positive as in a context in which inflation is generated purely by higher domestic demand.
From Berenberg they highlight the importance of executing this analysis within the central bank: “Central banks know what to do when higher inflation is driven by buoyant demand. They need to withdraw the punch by increasing financing costs.
However, this This strategy is of little use when the increase in inflation is due more to insufficient supply than to excess demand, as is currently the case in Europe. ”
However, “this advice to analyze the inflationary impact comes with a caveat: if inflation expectations and / or wage inflation threaten to take off too much , central banks should stop this increase before it takes hold.”
The latest ECB forecasts show that inflation will slow down to 1.7% in 2022 and 1.5% in 2023, forecasts that did not justify an increase in interest rates. But what if the ECB revises these forecasts upwards and they are close to or above 2%?
“The Governing Council stated in September that the current rise in inflation was expected to be largely temporary. It will now be crucial to hear at this week’s meeting to what extent this assessment has changed and whether the Governing Council sees any signs. that the different cost shocks have triggered a more lasting increase in inflation, “explains the Natixis economist.
The ECB has to vary its message, even if nothing changes in practice. “We expect the ECB to push against these more aggressive rate expectations , which are implicit in the current price of the eurozone money market curve. The market is pricing in a deposit rate hike in July 2022. On the contrary We assume that the ECB will wait until 2024 before considering a rate hike, “they say from Julius Baer.
In favor of the ECB’s argument are the mistakes made in the past, all related to ‘hawkish’ movements , rate hikes when it was not appropriate. The ECB can argue its cautious attitude due to the errors that led to “the premature rate hikes in 2009 (one hike) and 2011 (two hikes), so now they want to avoid making the same mistake,” they say from the Swiss bank.