ECB: Higher for longer – Now seen at 4%

Underlying inflation pressures have yet to improve for the ECB to signal an end to its policy rate hikes. Since the February meeting, the economic outlook and labour market still show resilience, pushing the eventual end of ECB hiking further out. 

Accordingly we adjust our expectations for the policy path from ECB and now expect a policy peak rate of 4% (deposit rate), with hikes of 50bp in March, 50bp in May, 25bp in June and 25bp in July. We naturally remain data dependent and may adjust the call at a later stage, but for now we see the risks around our baseline rate hike expectations as broadly balanced. Our revision comes on the back of more resilient economic activity and more 'sticky' underlying inflation developments.

We see the 50bp rate hike ECB intends to deliver at the March meeting as a 'done deal', but the key discussions at the meeting will be on the guidance for the May meeting on the back of the new staff projections. 

A 'sticky' problem

The brightening euro area economic outlook since the start of the year remains a double-edged sword for the ECB. Although headline inflation has on balance surprised on the downside compared to the December staff projections thanks to lower energy prices, the same cannot be said for core inflation which reached yet another record high of 5.6% in February. Underlying inflation measures have yet to show signs of peaking and selling-price expectations in business surveys suggest firms are far from finished passing on higher input and energy costs to consumers (see charts on page 3). In our baseline, core inflation will only dip below 4.5% in August.

This is partly also due to demand holding up better than expected. Unemployment remains at rock-bottom and surveys suggest firms intend to hire more, rather than plan large scale job cuts. Chinese pent-up demand will likely boost activity in the coming months and we have revised our euro area growth outlook upwards (see Euro macro notes - From recession to stagnation, 2 February). But although a fully-fledged recession will likely be avoided, a strong recovery is not yet in sight either, as monetary headwinds persist and stagnation still defines the outlook.

Energy prices have fallen sharply since the December projection and hence we expect headline inflation to be revised lower. That said, with the economy and labour market holding up better than expected, 'stickily' high core inflation will remain a worry for the ECB for some time yet, requiring policy rates to stay in restrictive territory for longer.

ECB focused on core inflation

The ECB has most recently been very attentive to the underlying inflation pressure building and its persistence, and as such also wages. Across the various underlying inflation measures that we (and the ECB) monitor, we only see the PCCI as having peaked, but all other underlying inflation measures are still increasing. Wages are crucial to follow in this discussion and the most recent Indeed Wage Tracker suggests wage growth around between 4.5-5% currently, which is not compatible with the 2% inflation target. 

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