■ While the Euro area activity dataﬂow since the start of the war has been mixed, the incoming information points to much higher and more persistent inﬂationary pressures than anticipated in the March ECB staff projections. We therefore look for the staff projections for headline inﬂation to rise sharply to 7.2% in 2022, 3.2% in 2023 and 2% in 2024.
■ We expect the Governing Council to announce next week that net APP purchases will end early in July, indicate that the inﬂation conditions for lift-off have been met and provide an effective pre-announcement for a July lift-off. We look for the Council to maintain that the normalisation process will be gradual and that ﬂexibility will remain a key element of monetary policy. During the press conference, we expect President Lagarde to reiterate the key signals provided in her recent blog post, guiding towards (1) 25bp hikes in each July and September and (2) a data dependent approach, where sequential hikes above the neutral rate might be needed if the Euro area economy overheats as a result of stronger demand.
■ Looking beyond next week, we maintain our baseline forecast that the ECB will hike the deposit rate by 25bp at back-to-back meetings to a slightly restrictive 1.5% in June next year. Given the incoming data and commentary by the ECB leadership, we believe that 25bp hikes are very likely in each July and September. While a number of national central bank governors have indicated openness to 50bp increments, we see a high hurdle for larger increments in July and September, given President Lagarde’s strong guidance towards quarter-point rises, limited evidence of strong second-round effects and the Council’s pledge to move gradually in light of downside risks related to the war.
■ The monetary policy outlook beyond the next couple of meetings, however, is unusually uncertain in both directions. On the hawkish side, underlying inﬂation could run persistently well above 2% if catch-up wage growth – which is already visible in German wage agreements – was compounded by de-anchoring inﬂation expectations. On the dovish side, we consider two scenarios. First, a re-emergence of sovereign stress that tightens ﬁnancial conditions in Southern Europe, weighing on growth and inﬂation. Second, a Russian gas ban which would likely be accompanied by weaker consumer conﬁdence, pushing the Euro area economy into a short, but sharp, recession.
■ In the event of second-round effects, we would expect the ECB to move faster (with 50bp hikes in both October and December) and further (to a terminal rate of 2%) to take the policy rate into clearly restrictive territory. In the sovereign stress scenario, we would look for a pause in the hiking cycle as the ECB is forced to activate its sovereign backstop and for a lower terminal rate than in our baseline (1%). Lastly, the coincidence of a gas ban and conﬁdence shock would likely stall the ECB hiking cycle early on as the economy slides into recession, and we would expect the lowest terminal rate in this case (0.5%). Despite these important downside risks, the probability-weighted average across our scenarios points to a terminal rate only slightly below our baseline scenario.
Recent ECB commentary suggests that the Governing Council is very likely to raise its inﬂation projections sharply at the June meeting, announce the end of QE and guide towards lift-off at the July meeting. The subsequent pace of hikes, however, remains subject to debate given slowing growth and stubbornly high inﬂation.
A Mixed, But Non-Recessionary Bag
The Euro area activity dataﬂow since the start of the war has been mixed. Services activity has held up better than expected, but industrial activity has slowed sharply, especially in Germany (Exhibit 1, left). For the rest of the year, we anticipate weak Euro area growth given the likelihood of a large drag on consumer spending from high energy prices for consumers, weaker trade and tighter ﬁnancial conditions. We therefore expect the ECB staff projections to show notably lower growth at 2.8% this year and 2.2% next year, somewhat above our own projections of 2.5% and 1.7% (Exhibit 2).
At the same time, the incoming information points to much higher and more persistent inﬂationary pressures than anticipated in the March projections. Headline HICP inﬂation hit a new record at 8.1% in the ﬂash May print and core inﬂation climbed to 3.8%, notably above consensus expectations. Moreover, a number of underlying inﬂation drivers have continued to ﬁrm, pointing to more persistent inﬂationary pressures in 2023-24. These include continued labour market improvement, the prospect of more pronounced second-round effects into inﬂation expectations and wage growth, the weaker Euro and persistent supply bottlenecks. Taken together, we therefore expect the ECB staff projections for headline inﬂation to rise to 7.2% in 2022, 3.2% in 2023 and 2% in 2024 (Exhibit 2).
The Beginning of the End of NIRP
The Governing Council is widely expected to announce next week that net APP purchases will end early in July, as signalled in recent ECB commentary (Exhibit 3, left). Moreover, we expect ECB ofﬁcials to (1) indicate that the inﬂation conditions for lift-off have been met and (2) provide an effective pre-announcement for July lift-off, noting that the deposit rate will rise soon unless the medium-term inﬂation outlook changes. We believe that the probability of a hike at the June meeting is very low, given the Council’s commitment to end APP before lift-off, the leadership’s strong guidance towards July lift-off and the small likelihood priced by ﬁnancial markets (as the ECB, like the Fed, rarely surprises markets with rate decisions on the day).
Regarding the speed of the exit, we expect the Governing Council to reiterate that increases in policy rates will be gradual and depend on the incoming data. We look for the ECB to reafﬁrm that ﬂexibility will remain a key element of monetary policy and that PEPP reinvestments will continue until at least the end of 2024, with ﬂexibility in the event of renewed market fragmentation. Moreover, we look for President Lagarde to reiterate in the press conference the key signals provided in her recent blog post, guiding towards (1) 25bp hikes in each July and September and (2) a data dependent approach, where sequential hikes above the neutral rate might be needed if the Euro area economy overheats as a result of stronger demand.
Looking beyond next week, we maintain our baseline forecast that the Governing Council will hike the deposit rate by 25bp at back-to-back meetings until reaching 1.5% in June next year, slightly above our 1.25% estimate of the equilibrium policy rate (Exhibit 3, right). Given the incoming data and commentary by the ECB leadership, we believe that 25bp hikes are very likely in each July and September. While a number of national central bank governors have indicated openness to 50bp increments (Exhibit 3, left), we see a high hurdle for larger increments in July and September, given President Lagarde’s strong guidance towards quarter-point rises, limited evidence of second-round effects and the Council’s pledge to move gradually in light of downside risks related to the war.
We expect the ECB’s policy normalisation process to entail a signiﬁcant reduction in excess liquidity, as net asset purchases end and long-term bank loans expire (Exhibit 4, left). The most important near-term driver of the liquidity drain is the outlook for bank reﬁnancing operations via TLTROs, with around EUR 1.2tn repayments due in June 2023 and a further EUR 1tn by June 2024. Although bank lending conditions tightened slightly in Q2, we do not look for additional ﬁnancing operations, unless bank lending conditions deteriorate signiﬁcantly. While the upcoming liquidity drain is likely to boost money market rates over and above shifts in the ECB policy rates, the pressures on money market rates should remain limited given large remaining excess liquidity (Exhibit 4, right).
Moving Up, But How Fast?
While our baseline expectation for the ECB’s hiking path is close to current market pricing, extraordinary volatility in terminal rate pricing is testament to two-sided uncertainty around the economic outlook. We therefore articulate the policy implications of our recently published scenarios for the Euro area outlook and derive a probability-weighted path to benchmark market pricing.
Inﬂation could become more entrenched compared to our baseline if second-round effects emerged, calling for a more restrictive policy path. Our statistical work on the anchoring of inﬂation expectations in the Euro area suggests that long-run expectations react to spot inﬂation and that this link has tightened recently. This could push even long-run survey-based expectations well above 2% (Exhibit 5, left). Although our falling headline inﬂation forecast mechanically implies that expectations should normalise again as of mid-2023, there’s a signiﬁcant risk that long-run inﬂation expectations would de-anchor further. This risk is corroborated by the shift of the probability that inﬂation exceeds 2% in the medium- to long-run across various Eurosystem surveys as recently pointed out by ECB Board Member Philip Lane (Exhibit 5, right).
Our work on second-round effects shows that this expectations channel can become self-fulﬁlling as higher inﬂation expectations push up wage growth, which in turn raises cost pressures that feed through to inﬂation. We are already seeing a notable pick-up in wage agreements, for example, in Germany (Exhibit 6, left). While these may reﬂect catch-up wage growth to compensate for the present cost-of-living shock—a more short-lived form of second-round effects—our wage Phillips Curve framework suggests that wage growth could rise persistently above levels that are consistent with 2% inﬂation (Exhibit 6, right).
Should second-round effects push up wage growth durably to well above 3%, core inﬂation pressures would build over time implying that core inﬂation stays above 2% over the next years in our forecast (Exhibit 7). In addition to this hawkish scenario, we consider two downside scenarios, which entail much weaker growth, a faster normalisation of underlying inﬂation and hence call for less policy tightening compared to our baseline.
First, sovereign stress could re-emerge as policy rates start to rise. Our stochastic debt sustainability framework implies an elevated risk of a rising debt-ratio in Italy, for example (Exhibit 8, left). The resulting FCI tightening in periphery countries affected by wider credit premia would likely slow growth and widen output gaps, which in turn would weigh on underlying inﬂation. Second, a Russian ban on gas exports to Europe combined with a consumer conﬁdence shock would likely push the Euro area into recession (Exhibit 8, right). While the gas supply shock would raise headline inﬂation by about 1 percentage point in this scenario, core inﬂation would eventually fall below 2% as declining demand increases slack.
Exhibit 9 (left) shows stylised policy rate paths informed by Taylor-rule prescriptions for the various scenarios. In the scenario with second-round effects pushing core inﬂation durably above 2% we would expect the ECB to hike faster and into clearly restrictive territory, with real rates turning positive in the course of 2023. Compared to our baseline of eight consecutive 25bp hikes from July, we would look for 50bp hikes in October and December as inﬂation expectations show clear signs of de-anchoring and wage growth accelerates strongly. This would take the terminal rate to 2%.
In the sovereign stress scenario, we assume that the ECB’s hiking cycle is interrupted in 2022Q1 as the approaching Italian general elections serve as a catalyst for markets to focus on sovereign debt concerns in Southern Europe. In the event, we would expect such concerns to be quelled and credit premia to be contained by the activation of an ECB sovereign backstop. We think the growth slowdown from FCI tightening through wider spreads would likely be insufﬁcient to contain inﬂation pressures without further policy tightening. To assert the primacy of the ECB’s inﬂation target we would look for two additional hikes in 2022Q2 to a terminal rate of 1% in this scenario.
The coincidence of a gas ban and a material conﬁdence shock would likely stall the ECB hiking cycle early on as we would expect the Euro area to slide into recession in 2022Q3. But once growth momentum recovers towards late 2023Q1 while inﬂation still runs well above target we would look for two last 25bp hikes. Clearly, the large conﬁdence-driven demand shock would limit the extent of policy tightening, such that we would expect the terminal rate to be the lowest in this scenario at 0.5%.
Finally, we use these scenarios to generate a probability-weighted ECB policy rate path (Exhibit 9, right). Based on our work on sovereign debt sustainability we attach a 25% probability to the emergence of sovereign stress. Markets have sharply repriced the risk of a Russian gas ban and we attach a 15% probability to this event. We see a material risk of second-round effects through higher wage growth and attach a 20% probability to this scenario. This leaves a 40% probability on our modal scenario. Taken together, these probabilities point to a probability-weighted terminal rate only about 15bp below our baseline scenario.