March ECB meeting preview: A large Russian cog in the policy recalibration

By Jeremy Hawkins, Senior European Economist
March 8, 2022

Ever since February’s meeting, this month’s ECB announcement has been widely expected to be a watershed moment for monetary policy. Although there is no chance of any move on key interest rates just yet, updated economic forecasts are likely to show yet another upward revision to the inflation outlook. This would provide additional ammunition for those Governing Council (GC) members who already see the central bank’s stance as too accommodative and might just pave the way for a hike in rates later in the year. Splits over policy have been widening since inflation started to accelerate last year and became even more apparent early last month when arch hawk Klaas Knot, the Dutch Central Bank President, broke ranks and said that he expected the ECB to raise interest rates in the fourth quarter. However, many others on the GC are more dovish and, crucially, in the wake of Russia’s invasion of Ukraine, the entire economic and financial outlook has become much more uncertain. Consequently, with volatility levels already highly elevated, the central bank will not want to risk destabilising financial markets any further.

For some time, financial markets have clearly believed the ECB to be behind the curve and speculation about a hike in official interest rates in 2022 was given a sizeable boost at the ECB’s post-meeting press conference in February. Hawkish comments then left financial markets discounting 3-month money rates back above zero by December, a rise of more than 50 basis points. However, the Ukraine crisis has prompted a reappraisal and rates are now seen still sub-zero throughout the year. That said, even the revised expected tightening schedule may well look too aggressive after Thursday’s announcement.

As it is, the path to higher borrowing costs is far from straightforward as official rates are not supposed to be raised until after the QE programme has been completed. Under current forward guidance, the GC “expects net purchases to end shortly before it starts raising the key ECB interest rates”. As far as the pandemic emergency purchase programme (PEPP) is concerned, this is not really an issue since purchases made under what has been for some while the ECB’s main QE arm are due to finish at the end of this month anyway.

However, the longstanding asset purchase programme (APP) is another matter. APP acquisitions are scheduled to be increased temporarily from their current monthly target of €20 billion to €40 billion in the second quarter and €30 billion in the third to reduce the hit to QE from the loss of the PEPP. Moreover, beyond that, the APP is open-ended and is supposed to continue for as long as thought necessary. Consequently, any future hike in rates would require the ECB to announce a cut-off date for the APP in advance and probably abort much of the increase in bond buying planned for the next couple of quarters. Prior to the Russian invasion, some GC members had suggested that purchases might end around August. However, now it is more likely that the central bank will be reluctant to commit to any end-date until the situation in Ukraine becomes clearer. In any event, the ECB may want to break the apparent link between the termination of QE and a rate hike, meaning that forward guidance could be amended to make a broader distinction between the two policy levers.

The tempering of rate hike speculation and a more subdued economic outlook have allowed the fixed income market to at least partially decouple from rapidly rising inflation. The increase in the entire Eurozone yield curve that followed the ECB’s February announcement has been fully unwound over the last couple of weeks as investors have sought the safety of governments bonds. Nonetheless, the market remains highly volatile and any sign of peace in Ukraine would probably see a renewed focus on inflation and a potentially sharp spike in yields.

Indeed, outside of developments in Ukraine, inflation remains by far and away the ECB’s major concern. Recent data have been distorted by changes to German VAT which lowered the headline and core annual rates in the second half of 2020 and boosted them over the latter half of 2021. However, these effects have now fallen out of the yearly calculation and the overall headline rate now essentially matches the rate with taxes held constant. To this end, the January and provisional February data were ominously poor and at some 5.8 percent, the overall mid-quarter rate was nearly 4 percentage points above the 2 percent target. Core inflation has been much better behaved but a 2.7 percent print for the narrow measure last month was also a new record high. The surge in energy and other commodity charges triggered by the Ukraine crisis will only serve to put additional upside pressure on consumer prices over coming months. Just last week, EU finance ministers indicated that they expect the invasion to boost inflation by around 2 percentage points. As it is, PPI inflation was already above 30 percent in January. To make matters worse, late in February the new German government approved a 2-stage hike in the minimum wage worth fully 22 percent by October. Covering some nearly 6.2 million workers, this will add fuel to the inflation fire.

All of which makes another upward revision to the ECB’s inflation forecast on Thursday inevitable and the extent of the adjustment together with any comment on the balance of risks will be watched closely. The so-called triple lock on policy means interest rates will not be raised until inflation is expected to reach 2 percent well ahead of the forecast horizon and durably thereafter and the underlying rate is seen consistent with inflation stabilising at the target level over the medium-term. December’s projections also included (another) hefty upward revision to near-term inflation but key will be what happens to the medium-term picture. If that keeps the rate below 2 percent, the bottom line would be that there is still no reason for the central bank to tighten.

More generally, since last month’s deliberations much of the economic news has been surprisingly upbeat as highlighted by Econoday’s economic consensus divergence index (ECDI) which has been fairly consistently positive since mid-February. However, a very disappointing January retail sales report pushed the real economy index (ECDI-P) into negative surprise territory and offered a timely reminder that Covid is still with us and just how volatile the data can be as a result. That said, more importantly anyway, the fallout from the Ukraine crisis has yet to appear in the hard data so upcoming business and consumer surveys will be key to getting an early idea of how the invasion has impacted sentiment. Some deterioration seems inevitable but the extent remains to be seen.

Covid cannot be ignored but since peaking in late January, new cases have plummeted and an increasing number of Eurozone governments are now implementing strategies aimed at learning to live with the disease rather than eradicating it altogether. Restrictions have eased right across the region and their removal should give a boost to economic activity going forward.

The minutes of the ECB’s February meeting confirmed a marked a shift to a much less sanguine view of inflation. The Ukraine crisis can only exacerbate current price trends but it will also dampen the economic recovery at a time when the Eurozone has only just reclaimed its pre-Covid level of output. As such, the central bank has a particularly difficult balancing job ahead; trying to contain the former without stalling the latter. Inflation will be top of the ECB’s agenda this week but the additional economic and financial uncertainties introduced by the Russian invasion probably mean that a major recalibration of policy is no longer on the table.


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