ECB Review: Cool heads, for now

• Macro view: The ECB left its policy rates and guidance unchanged, as expected. It’s a case of ‘wait and see’ for now. The messaging was relatively calm, but there were various indications that policymakers stand ready to tighten policy if inflation risks build. There was no attempt to push back against recent market repricing, and new ECB scenarios also laid bare the risk of second-round effects if energy prices remain elevated and policy is left unchanged. If the ECB does feel the need to tighten policy, we assume that rates would be taken to at least 2.50% (i.e. above the estimated neutral range).
• Markets view: Front-end yields have moved higher as market participants price a greater probability of a rate hike by the ECB. The OIS curve now shows 67bps of rate hikes by the end of the year. Equity markets have declined but not by enough to question the prospect of rate hikes and that is now providing some support for the euro. We still see EUR risks skewed to the downside on the basis that a further worsening of energy supply would like see risk assets fall more sharply that in turn would lessen the extent of tightening and provide renewed support for the dollar.

Macro view: Hawkish hints but the ECB keeps its options open

Calm and non-committal – for now

The ECB left policy unchanged for the sixth meeting in what was described as a unanimous decision. The “good place” motto was retired, unsurprisingly, and instead Lagarde said the ECB is starting from a “good base”. The core guidance was left unchanged: the ECB will follow a data-dependent and meeting-by-meeting approach, without any pre-commitment to a particular path.

The ECB certainly seems determined to keep its cool amid extreme uncertainty. The main message from today’s meeting was ‘wait and see’ and there was less in the way of hawkish messaging than we expected after various comments in the build-up to the meeting (see our preview here). After the surprisingly hawkish shift from the BoE earlier in the day (see here) it did feel like the ECB has a relatively steady hand on the tiller.

Still, as we’ve said previously, rate hikes are clearly conceivable, and there was a range of subtle messaging to that effect. Tellingly, there was no push-back against market pricing coming into the meeting for two hikes this year. The ECB stated that it is “closely monitoring” the situation and Lagarde said that the ECB will be “agile” to “do whatever is necessary”. New scenario analysis also laid out the risk of inflation persistence from second-round effects clearly (more on this below).

In terms of its reaction function, Lagarde said that officials will be “laser-focused” on data, citing survey indicators of selling prices and demand, and wage trackers. It was reported after the meeting that ‘ECB sources’ see a possibility of an April hike. But officials may want to see at least some evidence of second-round effects before embarking on any rate hikes. The ECB will also be watching closely for relevant government interventions (the Italian government has already approved a temporary 0.25 EUR cut to fuel duties). A lot could change by April, but there may be a preference to wait for more evidence and the updated projections which will come with the June meeting.

If the ECB does feel that tighter policy is justified, we’d certainly struggle to see a 25bp hike being a case of ‘one and done’. The deposit rate at 2.25% would still be within the ECB’s own estimate of the neutral range (i.e. 1.75-2.25%). We’d expect rates would be lifted to at least 2.50% in order to provide a stronger signal of the intention for policy to work against any upward drift in inflation expectations.

While there was acknowledgement that circumstances are different to 2022 with a less hot labour market and lower starting point in terms of current inflation, Lagarde also said that memories of the previous inflation shock might be “rather fresh” in a clear warning about second-round effects.

ECB rate expectations closely reflect energy price developments

The latest ECB projections show a significant but temporary inflation overshoot (dare we say ‘transitory’?)

The updated projections (here) are more relevant than expected. The cut-off date for the market assumptions was brought forward to 11 March and hence captures the energy shock to a significant extent. The baseline assumes an average oil price of 81.3 USD/bbl this year. In that case, inflation is expected to average 2.6% in 2026, a 0.7pp increase on the December projections. The headline rate is then projected to fall to 2.0% next year (dare we say “transitory”?).

With uncertainty so elevated, the ECB also presented “adverse” and “severe” scenarios. The adverse scenario is temporary in nature: it assumes energy disruptions until Q3 2026 before normalisation. Headline inflation is expected to peak slightly above 4% before quickly falling below target by end-2027 as energy prices decline. Growth is 0.3pp below the baseline in 2026 and 0.1pp lower in 2027.

The severe scenario assumes acute supply disruptions to year-end with damage to infrastructure. Inflation is seen peaking at 6.3% in Q1 2027 with “stronger indirect and second-round effects” then delaying the normalisation process (wage growth rises to close to 6%). We projected a very similar inflation peak and timing in our adverse scenario (see here).

The ECB estimates that in the severe case, the euro area economy would be pushed into a relatively shallow and short-lived recession. The scenarios clearly set out the difficulties facing policymakers now. There are no easy options when it comes to stagflation risks. For now, the ECB clearly wants to keep its options open, but if energy prices remain elevated we suspect that policymakers will struggle to maintain a passive approach.

Markets view: ECB well placed, limiting market reaction

EUR stronger with focus on Middle East 

The ECB statement and press conference have seen the front-end of the yield curve increase further, reinforced by Bloomberg reporting that “people familiar with the matter” indicated April was a live meeting for a rate hike. Earlier President Lagarde stated the ECB was in a “good position”. The 2-year yield fell back during the press conference after earlier spiking much higher in response to the surge in the Brent crude oil prices that has also eased back. EUR/USD was already higher on the day as the press conference began but did extend the move further as President Lagarde made clear that the ECB will be attentive to the upside inflation risks ahead.

There is not much for the financial markets to take away from this meeting specifically. The ECB communication was certainly much more balanced than the BoE and it appears the ECB has a little more tolerance over waiting to assess the energy impact on inflation. This perhaps comes from the fact that the ECB had already managed to return inflation to target unlike in the UK.

As stated above, the ECB does lay out an adverse and severe scenario and the inflation impacts are quite similar to what we outlined in our FX Weekly on Monday. The ECB only makes assumptions on crude oil and not FX but we maintain that under scenarios of bigger oil increases, the EUR/USD rate would likely drop further. In our worst-case scenario that would potentially see EUR/USD below the 1.1000-level. Today’s price action in EUR/USD and in other US dollar crosses is notable and despite the surge in energy prices today, the US dollar is weakening. During the months following the Russia invasion of Ukraine, the 2-year EZ-US swap spread plunged as investors focused on the negative hit to growth from the gas supply crunch. This time that same spread has jumped which could be helping to curtail US dollar buying appetite. Toward the end of the today’s press conference President Lagarde mentioned that the 2022-23 energy shock was “fresh in the mind” and the implication of that comment is that under the ECB’s adverse or severe scenarios, the reaction function could well be different with less tolerance shown. This ECB approach may provide some support for EUR/USD although the more severe the scenario becomes, the less important yield will become and hence we would still conclude that for now risks for EUR/USD are skewed to the downside.

EZ-US SWAP SPREAD HAS JUMPED IN REACTION TO MIDDLE EAST WAR

Source: Bloomberg, Macrobond & MUFG GMR