ECB Preview: Will Lagarde Follow Powell Into Early Dovish Capitulation
Expectations are for the ECB to keep rates unchanged for a second consecutive meeting after halting its hiking campaign in October.
As Newsquawk notes, In terms of recent economic developments, November’s flash CPI fell to 2.4% Y/Y from 2.9%, whilst the super-core metric declined to 3.6% Y/Y from 4.2%. Survey data saw a pick-up in the Eurozone composite PMI for November from 46.5 to 47.6, but ultimately is still suggestive of negative growth in Q4.
In terms of communications from ECB officials, great attention has been placed on remarks from Germany’s Schnabel, who noted that further hikes were “rather unlikely” after November inflation data cooled, and declined to endorse guidance for steady rates for several quarters. These remarks have subsequently accelerated pricing for 2024 rate cuts with a March reduction priced with around 60% probability.
Signalling for 2024 action may come via the accompanying macro projections, which ING suggests should see downward revisions for growth and inflation in 2024 and 2025. Finally, speculation continues to mount over the Bank’s balance sheet and a potential early conclusion to PEPP reinvestments after Lagarde stated on November 27th that PEPP will be discussed in the “not-so-distant future”. However, many desks are of the view that the December meeting would be too soon for such an adjustment.
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According to Rabobank, ECB sources suggested ahead of the meeting that core inflation being structurally below 3% would be a “necessary, but not sufficient condition” for discussing rate cuts. Recent inflation data were much softer than expected, and this had already spurred a rally in the money markets and fixed income space. Lack of pushback from the FOMC has only added to speculation that a rapid cutting cycle will commence in March. Will the ECB, like the Fed, accept this? Can they accept this?
Surely, the ECB cannot be blind to inflation risks even if the recent trend has surprised positively. Our own forecasts only see core inflation dip below 3% in June. Wage data have yet to confirm that the uptrend has been broken. And the Eurozone labor market remains historically tight with vacancy rates so high that any rise in unemployment could be quickly absorbed by demand for workers in other sectors. Real wages have started to recover, also supported by EU policies that have led to an increase in minimum wages in recognition that the lowest income brackets were hit disproportionally by the Covid-19 and the more recent energy shock.
This shift in policy shift has just gotten a fresh leg with yesterday’s announcement that the European Council and Parliament have reached a provisional deal to improve the working conditions for platform workers, aka the gig economy. The resulting directive aims to achieve two key improvements: i) it helps to determine the correct employment status of workers and ii) it establishes rules on the use of algorithm systems in the workplace. It is expected that stricter rules will lead to many workers previously assumed to be self-employed to be re-classified as employees of the digital platform. The European Commission estimates this number could be as high as around 5.5 million workers, or more than 2.5% of total employment in the EU. To this we can add several other factors that will keep future costs on an upward trend, such as another provisional deal between the council and the European Parliament, namely to enhance the protection of the environment and human rights in the EU and globally; this due diligence directive is aimed specifically at large companies.
Returning to the ECB decision. Some gradual easing of the effective policy stance isn’t detrimental to the ECB’s cause, considering that inflation is easing as well. However, repricing in money markets has outpaced the disinflationary process. As a result, the effective policy stance is substantially less restrictive. But now we may be in a situation where financial conditions have eased in such a rapid and signicant way that this could materially affect future growth and inflation. For illustration, high-yield spreads – supposed to be reflections of recession risk – have fallen to their lowest levels since Q1 2022 in both the US and Europe, equity markets are back to record-highs and European real forward rates, both at the short and longer end of the curve, have now fallen decisively below the zero threshold, the easiest stance of market rates since end-2021!
Recall that the ECB took into account the spillover of higher US rates into European markets when it concluded that further rate hikes were not necessary. If the ECB were fully time consistent, they surely have to hike now? Yet, a rate hike would probably backfire: in an environment of weakening growth this could fuel concerns that policymakers are overtightening.