Why the ECB Will Keep Hiking

Summary

• The market was premature in pricing that the ECB was about to slow its hiking. Ahead there is good reason to expect them to lean on more tightening than priced.
• Current inflation overshoots are the most important factor given that ECB forecasts are largely redundant.
• Positive GDP surprises, a long lag from surveys to the real economy and a better gas outlook mean the ECB needs to keep its foot on the tightening pedal.

Last week, the European Central Bank (ECB) raised its interest rates by 75bp, as we had expected. But rather than stress the need for more tightening (as we had also expected), President Christine Lagarde emphasised recession risk.

The market took Lagarde’s comments to be a dovish pivot. However, shortly after the meeting, ECB ‘officials’ clarified that they did not mean to suggest a slowing in hikes. High Eurozone national inflation figures drove another nail into the ‘pivot’ coffin, confirmed by Lagarde’s later comments that a mild recession will be insufficient to bring inflation back down.

The market is now beginning to understand that the ECB will have a hard time pivoting dovish anytime soon.

ECB Inflation Forecasts Have Little Credibility

Eurozone inflation is high, significantly above ECB expectations from just a month ago (Chart 2). But, perhaps more importantly, it is rising even when other countries are stable or falling – even when stripping out the most volatile elements (Chart 3).

These are two issues that the ECB will need to face. Its previous forecasts have been consistently wrong, partly on account of the assumption that inflation will return to (surprise, surprise) the ECB target of 2% (Chart 4).

There are strong reasons why such an assumption will not hold. The dynamic between Europe and Russia has changed permanently. Cheap gas, which suppressed price levels, is no longer an option. This means higher power prices, higher heating prices, and more expenditure on the infrastructure needed to offset the shortage (LNG terminals, wind farms, battery storage etc.)

Meanwhile, supply-chain pressures will remain an issue. The full effects of these are longer term and have been dampened by a slowing China (chasing zero COVID). One such example includes the reduction of Russian and Ukrainian fertiliser exports, which will likely mean reduced output in future harvests.

Together, this means they need to sustain tightening, not pivot.

Bar a (Literal) Change in the Wind, More ECB Tightening Needed

On the output front, the Eurozone economy continues to chug along. Headwinds have grown on the back of the Russian invasion of Ukraine, but hard data has outperformed ECB expectations (Chart 5). The surveys are incredibly negative (particularly among consumers), but the lag of its feed into hard data is long (Chart 6).

This probably means that the expected European recession will be too late and too shallow to offset near-term inflation. If winter is warm (and entails less gas usage), the risk of a near-term recession will further drop. That mean the ECB will need to step up its own action to slow the economy.

More Hikes, More Hawkish Talk

So the ECB is going to have a hard time justifying a tack dovish just yet. Where does that leave policy? Right now, the market is pricing the ECB will hike relatively little – only enough to take it 50bp above the neutral range (Chart 7). We, meanwhile, expect them to hike far further, out to 3% or more.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)