Weekly Update - ECB meeting under high inflation & geopolitical tensions
The ECB's monetary policy meeting of 10 March will take place against a backdrop of deep economic and financial uncertainty following the invasion of Ukraine and heavy sanctions on Russia. At its January meeting, the ECB left the door open to normalizing policy in 2022 (halting net asset purchases followed by a hike in the deposit facility rate) given the rising trend in inflation. Specifically, the ECB said it would rely on its medium-term economic projections to decide whether the conditions in its forward guidance (communication by a central bank as to the likely future course of monetary policy) to start renormalizing policy (inflation of 2% on a 2-3 year horizon and an underlying inflationary trend compatible with 2% inflation) had been met. Given February inflation figures, with headline inflation at 5.8% and core inflation at of 2.7%, ECB march forecast would most likely show that forward guidance condition have been met (chart 1). So, before the Ukraine invasion, the central scenario would have been an end to net asset purchases in Q3 2022 and the start of rate rises in Q4.
However, the Ukraine invasion and its potential fallout for the European economy has complicated the ECB normalization schedule, despite even stronger inflationary pressures. Although commodities themselves have so far escaped sanctions, the various financial sanctions and uncertainty as to how these might change will weigh heavily on Russia's exports of energy and other raw materials to Europe.
We are already seeing further rises in the price of crude, gas and other commodities as a result – meaning still higher inflation in coming months. This supply-side shock is bigger in Europe than in the United States due to the structure of Europe’s energy production. It has also come at a time when the European economy is still not back to pre-COVID levels (chart 2). So, any monetary tightening by the ECB would worsen the supply shock and potentially derail the growth outlook, which had been looking healthy before the Russian crisis. Finally, the start of monetary policy tightening could trigger a jump in volatility on capital markets and widening spreads between financing costs across the EU.
All of which makes us think the ECB will delay its schedule for policy normalisation, making no commitments as to dates for tightening and leaving the door open to reinvesting its asset purchase programme for longer. Nor should we rule out the possibility that Europe or individual countries could take fiscal steps to reduce energy bills if geopolitical tensions intensify or commodity prices rise further.