ECB preview: The prelude to December

Next week’s ECB meeting is largely a prelude to the December meeting, where new staff projections will base the foundation for the exact calibration of its instruments.

We expect ECB to flag risks to the outlook and as such not deviate from the current baseline and send new policy signals already now but wait for a new projections round in December. The September projections are already outdated given the recent spike in energy and slowing growth outlook. That means that we still expect ECB to repeat that they believe that the current inflation outlook is largely transitory, as Lagarde also said this weekend, but that narrative will be tested until the December meeting.

We believe that ECB will attempt to make the meeting as uneventful as possible. From a market perspective the euro area rates have been driven by the BoE’s change in tunes as well which have also raised concerns about the transitory narrative ECB is conveying. We expect significant pushbacks against the current rate hike pricing in December 22.

What if: Markets are already testing ECB on its narrative. For ECB to ‘give in’ to the current market pricing (with rate hike priced for Dec22), we would need to see ECB acknowledging upside risks to underlying inflation and risk of inflation expectations being entrenched already next week as a first step. That will later open the possibility for APP and change of forward guidance in reasonable time (H1 next year) for a rate hike to materialise. 

The fate of APP and delinking end of APP and first rate hike guidance…

PEPP is widely, if not by all, expected to end in March next year, and hence focus has changed to the ‘conventional’ purchase programme APP and how should it be calibrated. The devil is in the detail, but we expect that ECB can still end PEPP and send a patient / dovish signal.

In our view, a calendar-based forward guidance to e.g. June or December 2023 combined with a ‘well past the horizon of net asset purchases’ on the first rate hike similar to 2016- 2018 guidance is warranted – and should give markets the needed confirmation to significantly reprice ECB expectations of any normalisation (see discussion later). Such move would also be warranted in light of the strategy review outcome which showed that ECB will tolerate overshooting the 2% inflation target.

Several ‘trial balloons’ on the upcoming calibration have floated markets, from ECB could deviate from the capital key (in our view, this is very unlikely) to ECB increasing the focus on supra bonds as a way to mitigate the challenges with ISIN/Issuer limits (likely). As said above, the devil is in the detail on how markets will perceive it, but firstly ECB should settle on a narrative before discussing calibration measures. Will they continue to focus on financing conditions in its current form or will they change? We should not attach zero probability to any outcome, but in our view, a simple scale up from EUR20bn/month to EUR40bn/month will be the base. Some GC members have also advocated to flexibility under the APP to allow, for example, a special envelope, which could be used to respond to unexpected shocks. Some have argued for Greek bond purchases as well.

We expect a broad consensus at the meeting, but looking ahead, the divergence of views on the inflation and growth narrative will become more visible in coming weeks, and a big battle on the calibration will take place in December.

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