At today’s pivotal meeting, the European Central Bank’s (ECB) Governing Council (GC) firmly set its sight on exiting asset purchases as soon as possible without disrupting markets (too much). Compared to the scenario mapped out in December, purchases under the Asset Purchase Program (APP) are now decelerating from €40 billion in April to €20 billion in June, compressing the process previously planned for three quarters to three months. The ECB expects to stop purchases in the third quarter of the year, but left the door open to delays if financing conditions change significantly. ECB President Lagarde also stated several times that today’s decisions are not an acceleration but completely in line with previous decisions and conditional on the baseline projections playing out.
The ECB also confirmed that purchases under the Pandemic Emergency Purchase Program (PEPP) will end this month as planned but could be restarted if need were to arise. More importantly, Lagarde stressed the change in language regarding interest rates: the ECB no longer believes that policy rates might have to go lower, thereby allowing an upward adjustment of market pricing for the policy rate path. Moreover, the ECB retained the exit sequencing, but switched the focus: rather than ending asset purchases “shortly before” the first rate hike, the focus is now on ending asset purchases and hiking policy rates “sometime after”. Lagarde explained that this semantic inversion is meant to provide more room to be data-dependent rather than to signal how soon after rate increases may come.
Finally, the GC also stressed in its opening statement that the ECB stands ready to take whatever action is needed to safeguard financial stability. In the press conference, there was some discussion around the war in Ukraine and ongoing market volatility, especially in commodity and derivative markets, but Lagarde pointed to the primacy of fiscal policymakers in terms of response.
ECB staff also provided a new round of macroeconomic projections for the eurozone. The baseline scenario shows a rather moderate reduction in growth from 4.2% to 3.7% this year due to lower investment and household consumption. 2022 headline inflation was revised up by almost 2 percentage points (pp) to 5.1 with a peak in Q2 at about 5.7. Core measures were revised up as well, albeit by much less. For the outer years (2023 and 2024), revisions to growth are negligible, and inflation is ever closer to settling at target. As the cut-off date for the projections was in late February, the ECB helpfully reverted to the pandemic strategy of also providing alternative scenarios. Both scenarios fall on the downside, reflecting different degrees of escalation in Ukraine and therefore different (but higher) commodity price trajectories. The adverse scenario reflects a joint growth and inflation shock deriving from a moderate reduction in Russian gas supplies, with growth decelerating to 2.5% this year and inflation at 5.9%. The severe scenario foresees a more disruptive reduction in gas supplies, with inflation above 7% on average (but a very moderate additional growth reduction).
Regarding the forecasts, we fully appreciate the complexities involved given current volatility and we believe that providing alternative scenarios was the right way to communicate a range of outcomes that cannot be captured in one baseline. In fact, we believe that the adverse scenario is already more likely than the baseline scenario.
We had expected an acceleration of the tapering, but we had not expected President Lagarde’s refusal to call it just that. Instead, she repeated several times that this new timetable did not reflect an acceleration, was consistent with previous decisions and conditional on the baseline scenario playing out. In her view, today’s decisions added optionality at a time of extremely high uncertainty, whereas we believe that she complicated the ECB’s communications strategy. On the other hand, the change in sequencing language strikes us as quite helpful, and consistent with the data-dependency mantra of the ECB. In all likelihood, there will be very little time between ending asset purchases and the first hike, but that isn’t clear at this point.
We were also struck by Lagarde’s statement that the ECB does not see wage pressures yet as we had thought the discussion had evolved from focusing on this backward-looking indicator. In many ways, the ever-escalating inflation trajectories make higher wage inflation almost a given, especially as minimum wages are also likely to rise by a substantial amount in Europe’s largest economy, pushing the wage pyramid higher in the context of tight labour markets.
Overall, today’s ECB meeting came as a hawkish surprise to markets focused on the escalation in Ukraine. This is reflected by a jump in sovereign bond yields and wider spreads of periphery bonds, as well as higher probability of rate hikes this year. The latter is somewhat mechanical as rates are no longer expected to potentially go lower. That said, we are unclear what the ECB wanted to achieve today; the market clearly perceived this as a rush to the exit while accepting higher yields and spreads. For us, this confirms our expectations that bond yields should continue to drift higher in Europe, notwithstanding Lagarde’s invitation to “have no doubt” that the ECB will protect financial stability.