Weekly Update - European Central Bank toughens its tone

Tone of Bank's statement takes markets by surprise
The European Central Bank (ECB) made no changes to its monetary policy levers at the February meeting. However, in her post-release statement, Christine Lagarde stressed that risks to the Bank's inflation forecasts lay on the upside and, in a departure from previous communications, did not rule out raising policy rates before year-end.

Uncertainties on recent inflationary trends
The main reason behind the ECB's shift in tone was the latest upside surprise in the January inflation figures to 5.1%, up from 5.0% in December and well above the consensus forecast of 4.4%. Most of this can still be attributed to energy prices. But other components are also edging up, enough to eclipse the fading German VAT effect of last year. These trends raise fears that price pressures could be spreading to all goods and services without yet being visible in wages.
While there are undoubtedly risks in the air, we think it is premature to significantly revise inflation projections for the coming year. Euro area price pressures  remain largely imported (energy prices, pressure on production chains) and could have a bigger impact on economic growth than on the inflationary outlook.

Markets have over-corrected their expectations
Investors are now expecting the ECB to significantly increase its inflation forecasts at its next meeting in March. If this proves correct, it would imply a two-stage adjustment to asset purchase programmes: an end to the pandemic emergency purchase programme (PEPP) by March followed by a faster wind-down of the pre-Covid APP with purchases ending completely in H2 2022. The ECB may then hike its deposit rate, currently at -0,50% by the end of the year. Money markets, however, are expecting a more dramatic tightening, with asset buying ending in June and 4 rate hikes in 2022.
Admittedly ECB policy could revert more rapidly to normal in 2022 assuming the economy remains healthy. However, we see current market expectations as excessive at the current stage of euro area's recovery cycle. While economies are heading solidly back to normal, they have yet to regain their pre-COVID growth rates. Any tightening of monetary and financial conditions, as we see from the market’s reaction to Christine Lagarde's statements, would hamper the ongoing recovery. 

Conclusion 
The ECB has clearly toughened its tone in response to higher-than-expected inflationary figures. Markets have over-revised their expectations for monetary policy. We expect some downgrading of these expectations, which would risk imperiling the health of economic activity in the euro area.

Read full article