ECB: The Eurozone Is Not The US And The Output Gap Is Still Closing

Christine Lagarde IMF director

Annalisa Piazza (MFS IM) | Despite no changes in the policy stance, the tone of the press conference was clearly more hawkish than anticipated. Lagarde noted that risks around inflation are skewed to the upside, especially in the short-term and the March projections on inflation will set the stage for future policy moves. Recent inflation developments are a reason of concern across the Governing Council as second round effects from higher energy prices are filtering through come goods and services prices. Energy explains around 50% of the current headline inflation but concerns about long term impact on the rest of the basket have intensified. This is a material shift from December when the spike in inflation was mainly seen as temporary.

Lagarde made clear that – despite the improvement in the labour market – wage growth is subdued, and a certain degree of rising wages will be tolerated this year. At the same time, the ECB needs to prevent negative vicious circles to materialize as the 2% inflation target in the medium term remains the ECB key objective. Risks around growth are balance although short term GDP is seen as relatively weak on containment measures. The picture looks brighter in the medium term. In a nutshell, the short-term growth scenario will not be on the way of future policy decisions.

The March Governing Council meeting will be crucial as the ECB will have more data to look at and more analysis on the impact of the current inflation path on medium term developments. Current inflation expectations (as measured by surveys and market measures) are close to 2% in the medium term and the ECB needs to re-assess whether upside risks also apply to 2023 and 2024 before changing its policy stance.

Policy outlook and market view: A rate hike this year remains a tail risk but not our baseline scenario as Lagarde reiterated the sequencing of hiking rates only after QE ends remain valid, but we now cannot rule out that – comes March – the ECB decides to slightly change its APP Programme. Lagarde stressed the need to remain gradual in policy adjustments as the economy still needs an accommodative policy stance, making clear the Eurozone is not the US and the output gap is still closing. That said, markets have become increasingly nervous and the reaction to today’s ECB press conference has been significant, with OIS pricing in a hike already in June and a total of around 40bp by the end of the year. With inflation remaining stubbornly high for different reasons that go beyond the ECB control, we rule out the ECB will start hiking rates as early as the market currently pricing in. That said, today’s shift to a more hawkish stance is unlikely to change anytime soon, especially going into a time of improved activity in Q2-Q3.

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