Policymakers in Europe are taking a different approach to the same shock

There is a good deal of optimism around a US-Iran deal heading into the weekend, as my colleague discussed here. Markets have responded positively to credible reports of progress with Brent oil down over 10% since last Friday. Our sense is that a lot of good news is already priced in. However there is certainly scope for wholesale energy prices to fall further if ships begin to transit the Strait without incident.  At the time of writing, the implied probability from Polymarket is 45% that shipping through the Strait of Hormuz will have normalised by end-June and almost 65% by end-July.

But even if shipping flows do normalise, the recovery in energy production will take time. We also expect a persistent geopolitical risk premium around energy pricing (Iran may see the reversal of any reopening as a relatively low-cost form of re-escalation if talks were to falter). Our pre-conflict baseline was for oil around the 70 USD mark this year, which looks well out of reach even in the case of a deal.

It is now clear that there is plenty of inflation in the pipeline, regardless of geopolitical developments. Headline inflation rates in both the euro area and the UK are set to exceed target until at least next spring with price pressures percolating through the European economy over coming months.

But a key development in recent weeks has been increasing divergence in the response from the ECB and BoE to what is essentially the same shock. At the start of the conflict we assumed that both central banks would want to tackle second-round inflation risks on the front foot with some measured pre-emptive tightening. While the BoE has policy in marginally restrictive territory (unlike the ECB which is at neutral), the UK has more recent experience of above-target inflation with the headline rate peaking at 3.8% last year. To our minds, that raises the risk of structural shifts in wage and price-setting behaviour.

However, the June meetings are now approaching and there is no sign of any urgency from the BoE. But for the ECB it is now a high bar for officials not to hike at the upcoming meeting on 11 June, even in the case of a US-Iran deal before then.

The ECB has sent a clear signal that it intends to raise rates in June

There has been plenty of groundwork in recent speeches for an ECB hike at the next meeting. Lagarde said this week that it is when “monetary policy decisions are politically fraught and economically costly that credibility is most needed”. Chief Economist Philip Lane confirmed that a further upward adjustment to the inflation forecast in June is likely. Influential hawk Isabel Schnabel explicitly said that a “June hike will be needed” and that “looking through is no longer an option”. The minutes from the previous meeting were also released this week and show that an April hike (which was our initial post-conflict call) was openly discussed.

The HICP data this week was generally in line with expectations and will support tightening. The headline German figure eased to 2.7% on the back of temporary government fuel tax relief, but higher rates elsewhere leave the euro area aggregate number on course to exceed 3%. We think the 4% mark will be reached by year-end.

On the activity side, today’s downward revision to French Q1 GDP (now estimated at -0.1% Q/Q) reinforced our concerns about downside risks to growth. Following dire French surveys in May, a technical recession in France now looks more likely than not. There was better news in Italy with a healthy upward revision to the Q1 estimate (0.2% to 0.3% Q/Q), which offsets the impact on the euro area aggregate. But in terms of monetary policy it still seems clear that the ECB is relatively more focused on inflation risks than growth risks at this stage. We continue to expect 50bp of ECB tightening this year.

The BoE will not be rushed

This all marks a contrast with the BoE which is showing some willingness to be patient. There was a relatively explicit (if technical) discussion of the inflation-activity trade-off in a speech by Governor Bailey today. The key line is: “monetary policy cannot wait for conclusive evidence of the strength of second-round effects. But responding too early may generate undesirable volatility in output”. The messaging tallies with what we heard at last week’s Treasury Select Committee appearance. This is not a central bank which is minded to raise rates in June, but might do further down the line (we still think that July is possible).

It’s worth stressing that UK data has been on the soft side recently (see our take on the latest labour market and CPI numbers here and here). After jawboning rate expectations higher following the hawkish hold in March, BoE officials are leaning on the extra breathing space afforded by immediately tighter financial conditions. It’s also relevant that pre-conflict expectations for one or two cuts have been scrubbed this year. But a hike is priced by November and at some point this tightening of financial conditions will unwind if there is a sense that policymakers won’t follow through with action. There are also wider credibility risks (something which the ECB seems more aware of than the BoE on the basis of the Lagarde speech mentioned above). All told, we continue to expect two BoE hikes this year for now, but have less conviction around that given the lack of initial urgency and softness in recent data.

Zooming out, a US-Iran deal would certainly simplify the outlook. Both the BoE and ECB would worry less about tail risks and focus more on underlying price pass-through. Early tightening from either would still be a judgement call based on survey signals rather than definitive evidence e.g. of actual higher wage growth. But policymakers would be less fearful of the policy errors around tightening into a recession and happier to frame hikes as a ‘calibration’ or ‘measured adjustment’, which could later be unwound if second-round risks do not materialise.  

More clues around the extent second-round risks

There will be another flurry of ECB & BoE speakers ahead of their respective pre-meeting quiet periods. We expect similar rhetoric to what’s been heard in recent weeks, but the reaction to any progress in US-Iran talks would be a big market focus. There will also be a lot of policy-relevant data next week. Officials will be watching a range of survey numbers, including the ECB’s consumer inflation expectations gauges and the BoE’s Decision Maker Panel release, to gauge for second-round risks. There will also be euro area inflation (we expect headline will move above 3.0% despite the softer German print this week), PPI and compensation per employee.