“.. push and pull like a magnet do“
Ed Sheeran, Shape of You
Last week, we discussed the UK economic data trajectory in the context of the fast-approaching September Bank of England policy meeting. We argued that while it has been clear that the UK has suffered from a more acutely tight labour market/skills shortage than some other countries, and that the supply of services has also suffered shocks alongside the more obvious energy and goods supply shocks, demand has been increasingly weakening for a significant period of time, in our view. Regular readers will know that we have been firmly in the Tenreyro/Dhingra camp on monetary policy for many months now - concerned that the underlying domestic demand momentum is likely much weaker than some of the aggregate data (certainly price data) suggest. Furthermore, we argued that we believe that the decision on rates next week is now likely to be a very close call for the MPC.
Ultimately, we argued that there is a credible case for the MPC to explore the implementation of the policy alluded to by the Chief Economist and Deputy Governor (Pill and Broadbent), that there are multiple paths to achieving the same outcome on inflation (arguing the economic equivalence of raising rates and then cutting them over an extended period and holding them steady for an equivalent - or longer - period). This week’s ECB meeting may well have paved the way for the Bank of England to do just that.
The ECB raised rates 25bps to 4.00% in a move that was relatively controversial going into the meeting. As recently as the US Labour Day holiday in early September, markets were pricing in just 6bps of ECB tightening at this week’s meeting. Following some slightly better news out of China and a Reuters story suggesting that the ECB forecast for 2024 would remain above 3%, markets tightened their expectations as a function of the primacy of the ECB mandate - price stability - despite some emanating fears over eurozone growth. That said, going into the meeting, analysts were almost exactly 50:50 (25bp hike or unchanged) and market pricing had risen to roughly 15bps (or 60%).
In many respects, however, it was not the actions, but the words that held the most significance at this week’s meeting. In short, it was dominated by the updated staff projections - the expected path of growth and inflation. Growth projections were lowered throughout the forecast horizon.
The ECB staff projections showed downgraded growth projections: 0.7% for 2023 (vs. 0.9% previously), 1.0% for 2024 (vs. 1.5% previously) and 1.5% for 2025 (vs. 1.6% previously). With the backdrop for inflation more complex: 5.6% in 2.23 (5.4% prev.), 3.2% in 2024 (3.0% prev.) and 2.1% in 2025 (2.2% prev.)
In the press conference, President of the ECB expanded on the updated forecasts, highlighting that most of the downgrade to the 2024 growth forecast (the biggest downgrade) is attributable to carryover from weaker near-term growth (as reflected in recent PMI weakness). Lagarde offered a more constructive growth view relative to the current uncertainties, as inflation declines but strong wage gains and a tight labour market suggest real wage gains to support domestic demand into 2024. Lagarde also pointed out downside risks to growth through bigger than expected monetary policy passthrough to financial conditions or further slowing in the global economy weigh. Alternatively, stronger real incomes and reduced uncertainty could see a more constructive picture materialise.
On inflation, while the ECB expect more persistent pressure than they did in the June projections in the near term, Lagarde acknowledged that a weaker growth environment may bring lower price pressures over the medium term. Alternatively, energy and food (as a function of weather risks), a lasting rise in inflation expectations, or even wages, could drive inflation higher over the medium term.
Ultimately, the emphasis of the resultant press conference was that the ECB feels that the policy rate is set to a ‘sufficiently restrictive level’, and that now the core focus of policy is on the guidance of the ‘duration’ over which rates need to remain restrictive. In order to gauge progress in this regard, the ECB will focus on i) the incoming economic and financial data, ii) the dynamics of underlying inflation and iii) the effective transmission of monetary policy (uniformity across member states).
While in some respects, Lagarde emphasised the downside risks to growth (and highlighted that momentum was also slowing in the service sector - despite continued impressive labour market tightness), and even the further weakening of credit dynamics undermining household and corporate loans, the overall message was one of balance. The inflation has continued to decline but has remained too high for too long.
The OIS curve is pricing another 11bps of hikes by year end, as the statement implies that rates have reached a level that will make a "substantial contribution" to returning inflation to target if maintained for a sufficiently long duration - leaving a credible risk premium for higher rates (Indeed, when drawn, Lagarde was clear that the ECB “cannot say rate have reached their peak”). With no reference to "risk management", a phrase that appeared in the last ECB minutes indicating concerns about slowing growth, ultimately, we would argue that this week’s ECB was quite balanced.
If we circle back to the Bank of England (we will expand upon the implications of the Fed relative to the ECB in a future post), the stance of the ECB - switching to holding from hiking - has important connotations for the BoE. Last week we suggested that there is a credible rationale for the Bank of England to adopt a policy of a prolonged pause in policy - made more credible by last MPC meeting’s emphasis from Governor Bailey that the current policy setting is restrictive, and further so by the ECB’s latest policy iteration. Indeed, to quote Ed Sheeran, the forces of growth and inflation going forward likely “push and pull like a magnet do”!, We would even argue that at the current juncture it would make sense for the BoE to “come on now follow my (ECB) lead”!
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