ECB Monitor: Stubborn Core Inflation Suggests 50bp in May and 4% Terminal

Summary

• Recently, ECB speakers have toned down their hawkishness, rallying instead behind buzz-phrases such as ‘most hiking being behind us’ and ‘data dependence’.
• However, the fundamental inflation picture has not improved. Recent data releases suggest that the ECB will need to come to terms with far higher core inflation this year than they currently assume. As markets continue to normalise following the banking volatility, I expect the hawkish pricing to resume.
• I expect core inflation will remain stubbornly high in the coming months (staying above 5.5%). This will outweigh the rapid decline in headline inflation.
• Consequently, I see a strong risk for another 50bp hike in May and a terminal rate above 4%.

Link to Most Recent ECB Meeting Minutes (March 2023)

Toned Down Hawkishness Unlikely to Last

Since the last ECB meeting, and after the March banking sector volatility, most policymaker comments have shifted away from the unconditional need to hike and towards the data dependence of May’s decision. This is unsurprising given the criticisms levelled at the tactic (particularly from the likes of Bank of Italy Governor Ignazio Visco).

Policymakers also broadly agree the ‘bulk of hiking’ is behind them, which is self-evident unless an 8% terminal rate is possible.

Continued Core Inflation Beats Would Justify 50bp in May

Right now, a 50bp hike in May is my central case (the market is pricing 25bp). I estimate most major voters are either in favour of 50bp or undecided between it and 25bp. Should my expectation that core inflation will remain above ECB forecasts prove correct, this should be enough to push the consensus to 50bp.

I am not alone in thinking that the ECB’s estimates for core inflation look optimistic. The March minutes set that out clearly. Meanwhile, although the doves would like to focus on headline inflation as it falls (recall: they were keen to look through it while it was rising), ECB President Christine Lagarde’s recent speeches reaffirm the emphasis on underlying inflation instead.

Banking Sector Woes Unlikely to Prevent Near-Term Hawkishness

Banking sector stress is a factor in the recent ‘dovish’ shift. It follows that if banks tighten credit conditions, the ECB will need to hike less. True, the Governing Council (GC) disagree on exactly how to balance price stability and financial (members Visco, and to an extent Klaas Knot seem more wary; Madis Müller and Olli Rehn less so). However, if market conditions are dire, they will likely take the prudent choice and pause.

Conditions have improved considerably since the last meeting (Appendix). The clearest data on whether banks are tightening lending conditions would come from the EZ bank lending survey. However, this may come out too late to be a strong input at the next few meetings (Q2 data is released end-July). Consequently, in the near term, I expect that speakers who had been more cautious due to market moves will find their hawkish feet again.

March Inflation – A One-Off Repricing Miss

Final March Eurozone inflation confirmed that headline dropped to +6.9% YoY (from +8.5%), while core rose another 0.1pp to +5.7% (Chart 1). However, this was still a decent drop in MoM core versus the month’s typical value, driven largely by an undershoot in clothing inflation (Chart 2).

Expect Core Inflation to Remain Elevated Ahead

This was the first MoM core undershoot in a year but is easily explainable. March typically sees high repricing action. The larger-than-typical repricing in January likely meant less repricing was needed in March (Chart 3). I expect this one-off effect does not repeat in April. Consequently, there will continue to be strong upside risk to the ECB’s expectation for an average +4.6% core reading for this year (Chart 4).

Clothing Was Main Source of March Core MoM Slowdown

The March repricing effect was most notable in clothing. There, the underperformance in March correlates strongly with the larger re-pricing in January. This is a relatively stable historical relationship, albeit one that has seen larger movements since the GFC (Chart 5).

ECB to Keep Hiking – Another 50bp Possible in May

Right now, underlying inflation is clearly the biggest concern. Alongside Lagarde, speakers from across the spectrum (including Luis de Guindos, Joachim Nagel, François Villeroy, Pablo Hernández de Cos, Müller and Boris Vujčić) have cited it as a concern and/or its slowing being necessary for a pause.

By my calculations, core inflation should stabilise above +5.5% YoY over the next few months. April preliminary data is due at the start of May, which will likely confirm that the ECB’s projections are too low. The offset will be that even with soaring food prices, energy prices could drag headline inflation lower. Short of a new energy price crisis, this will likely see headline undershoot near-term ECB forecasts.

On balance, given Lagarde’s focus, continued tightness in labour markets and increased focus on corporate profits should leave this a net-hawkish outturn – even more so if high underlying inflation were to feed into inflation expectations (Appendix: Chart A6).

It therefore seems highly likely that the May hike is another 50bp. I have previously noted the possibility of the ECB hiking above 4%; I now shift my base case to a 4% terminal rate. Before SVB’s collapse, the market had come to agree with this. However, it has pared pricing despite the fundamentals having worsened since then (Chart 6).

Recent Voter Comments

Appendix: Stress, Surveys and Economic Data

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.

Photo Credit: depositphotos.com

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