For next week’s ECB meeting, another 50bp rate hike has been well telegraphed and fully priced by markets. We expect the ECB to continue to sound very hawkish and signal that further rate hikes are coming, in particular giving guidance for another 50bp hike in March. The ECB surprised on the hawkish side in December, which immediately tightened financial conditions, but during January financial conditions reversed back to pre-December levels. Consequently, we expect Lagarde to give a strong reminder to markets to tighten financial conditions.
Since the December meeting, the economic outlook has brightened, but this is a doubleedged sword for the ECB. While headline inflation declined in December and is expected to head lower throughout most of the year, the stickiness of underlying inflation remains a headache for the ECB.
On the technical side, the ECB said at the December meeting that it will publish the technical details of the reduction in the APP portfolio.
Resilient economy is a double-edged sword for the ECB
Since the December meeting, the economic outlook has brightened. Thanks to the effects of expansionary fiscal policies and easing supply bottlenecks, economic activity remained fairly resilient and energy crisis fears have abated with natural gas prices returning to their pre-war levels. In January we even saw the euro area PMI composite returning to marginally expansionary territory. However, for the ECB the brightening growth outlook is a double-edged sword. Chinese pent-up demand has the potential to boost activity during the spring and summer, but it could also worsen the inflationary trade-off, as Europe and China will increasingly compete on a still tight global energy market (Euro macro notes - The China connection: short-term boost, long-term worry, 12 January).
While markets have focused on the decline in headline inflation that could materialise faster than forecast by the ECB in December considering the lower energy market prices, core inflation is still rising. For the time being, lower energy prices and base effects as well as government interventions are pushing down headline inflation. However, with a resilient labour market and still elevated selling price expectations, high core inflation is set to remain a worry for the ECB for some time. In a positive development, consumer inflation expectations and high-frequency wage growth measures have eased a bit lately, but they remain at too elevated levels to be consistent with market expectations of (core) inflation already returning to the 2% target by the end of this year. We also see the potential for an upside surprise in the January HICP figures released next week (see Euro inflation notes – January surprises, 25 January), adding to the risk of more ECB hikes to come.
A 50bp hike is the easy decision, communication is difficult
The decision next week to hike 50bp has been very well telegraphed to markets and hence markets have exactly 50bp priced for the meeting. Therefore markets’ focus will be on the guidance for hikes beyond that. As headline inflation has come lower and will continue through the year, the doves are likely to argue for signals to slow the hiking pace, like what Bloomberg’s ECB sources story suggested last week. However, with underlying inflation expected to stay sticky for longer and only return to 2% in 2024, we expect the hawks and Lagarde to send hawkish signals for further tightening to come. Since the December meeting, the peak of policy rate hikes has come higher by 51bp to 3.3% (in €STR terms, hence c.3.4% in deposit rate equivalent). This is broadly in line with our anticipation of 50bp next week, followed by another 50bp in March and 25bp in May, which will bring the deposit rate to 3.25%. We still see risks skewed to more than the 3.25% as in our baseline scenario.
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