April ECB meeting preview: Caught between a rock and a hard place

By Jeremy Hawkins, Senior European Economist
April 12, 2022

The surprisingly hawkish (but hardly aggressive) recalibration of policy announced at the ECB’s March meeting was supposed to reassure investors that the central bank was fully aware that inflation was too high and that it was willing to act. However, since then pressure to do more to combat price rises that are now running at nearly four times the target rate has intensified significantly and negative interest rates are looking more inappropriate than ever. Another shift in the stance as soon as this week is unlikely but the ECB’s credibility could suffer badly should it fail to turn up the rhetoric on the need to meet its medium-term price stability goals. That said, the war in Ukraine is clearly inflicting damage on Eurozone economic activity and any outright tightening of policy would raise the very real risk of tipping the economy into recession. Policy dilemmas do not get much worse.

Last month’s policy changes trimmed planned QE asset purchases from €120 billion to €90 billion this quarter and deleted the previous €90 billion slated for July-September. The hope was that, with the pandemic emergency purchase programme (PEPP) being terminated at the end of March, the longstanding asset purchase programme (APP) would finally be wound up next quarter. However, since the removal of the APP will be data-dependent there is still no firm termination date and, for borrowing costs, this is important as forward guidance has any adjustments to the key ECB interest rates only taking place “some time” after APP purchases have been halted.

The surge in inflation has caught the central bank and financial markets by surprise. At fully 7.5 percent, the flash headline rate in March was up some 1.6 percentage points versus its final mark in February and, by some margin, a new all-time high. Ominously too, this was also the steepest monthly increase on record. Inevitably, energy prices (up nearly 45 percent on the year) did most of the damage, alone contributing around 4 percentage points to the headline rate, but underlying prices accelerated too. The narrow core rate hit an unprecedented 3.0 percent, a full 1 percentage point above the target level while the other main underlying gauge (excluding energy and unprocessed food) was even higher at 3.2 percent. Making matters worse, PPI inflation had already surged to an unprecedented 31.4 percent in February even before energy prices took off in early March. In addition, expected selling prices hit new all-time highs in both manufacturing and services last month as supply chains remained seriously disrupted.

For now, the ECB’s key deposit rate remains at minus 0.50 percent, below the refi rate at 0.00 percent and the rate on the marginal lending facility at 0.25 percent. Without a change in forward guidance, all will be held at their respective current levels until at least the third quarter. Nonetheless, the worsening inflation backdrop has made financial markets all the more convinced that the ECB will be forced to prioritise tackling inflation over supporting the real economy. Since the March discussions, expectations for higher interest rates have been ratcheted up by enough to put 3-month money rates at around 0.40 percent at year-end, nearly 90 basis points above current levels and 50 basis points higher than at the time of the last meeting.

Even so, those doves on the Governing Council who were far from convinced that policy should be made less accommodative before the Ukraine crisis began, will now be even more cautious about the economic outlook. At the moment there is little hard data available to provide any real indication of how much the war has impacted Eurozone activity but a number of polls have noted a marked worsening in confidence. In particular, the EU Commission’s March survey of economic sentiment (ESI) found both its lowest level since March 2021 and, potentially more importantly, outside of the initial reaction to Covid, the steepest monthly decline in more than 13 years. With the change in the ESI showing a 76 percent correlation with quarterly GDP growth, the omens are not good for output in the second quarter.

Most sectors of the economy seem to have been hit by the Ukraine fallout, notably households which in March suffered their second-sharpest monthly drop in confidence on record. In addition, the deterioration looks to have been widespread across the region. April’s data will probably look even worse as inflation continues to accelerate, sanctions bite more fully and employment growth begins to slow. How much of an effect on consumption all of this might have is hard to say but, having subtracted 0.3 percentage points from economic growth at the end of last year, consumers may also struggle to make a positive contribution this quarter despite looser Covid restrictions.

As it is, recent economic data have been surprisingly weak. Since early March, Econoday’s economic consensus divergence index (ECDI) has been consistently below zero, a pattern mirrored by its real activity counterpart that removes the effects of inflation shocks (ECDI-P). Only part of the underperformance will reflect Ukraine effects but such readings warn that earlier Eurozone growth forecasts for 2022 are likely to prove too bullish, probably significantly so.

Covid is also still an issue for the Eurozone economy. New cases in the last wave peaked in late January but a subsequent loosening of restrictions saw a renewed rise in March. The latest data suggest that, in general, that too has now run its course but many member states still have very high national readings. Earlier this month in Germany the level was deemed worrying enough that previous plans to remove at the start of May the current mandatory self-isolation period after a positive test were shelved. This will add to the staffing problems caused by a very tight labour market and could well dampen growth while providing a fresh boost to wages.

All of which leaves the ECB caught between the rock that is inflation being far too high and the hard place that could be recession should policy be tightened too soon or too rapidly. Inflation will have to be the top priority if only for the sake of central bank credibility but aggressive monetary tightening will have to wait.

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