ECB’s Lagarde Likely to Maintain Course But Stress Optionality, Gradualism and Flexibility

8 March 2022

By David Barwick – FRANKFURT (Econostream) – The March monetary policy meeting of the European Central Bank Governing Council comes down to the question of whether the additional uncertainty and the concern about growth resulting from Russian state terrorism against its neighbour warrant a pause in the incipient process of policy normalisation.

The question is complicated. On the one hand, war is about as dramatic an element of uncertainty as one can imagine, which is why ECB Executive Board member Fabio Panetta recently called for ‘small steps in a dark room’.

On the other hand, there is the ECB’s mandate of price stability, which is increasingly under threat, including from the fallout of Russian military aggression itself. At least in the short term and probably beyond, there is no question that Russian dictator Vladimir Putin’s Ukrainian obsession will also be felt in the form of increased price pressures.

And these were already high and mounting, delivering one upside surprise after another, most recently Eurozone HICP of 5.8% last month, well above both January’s 5.1% and expectations.

At a longer time horizon, vistas are enshrouded in fog, but the massive further climb of prices for energy and other commodities could induce recession. While this would normally go hand in hand with enfeebled price pressures, such a slump would be stagflationary, so that ECB policymakers could not expect relief on the price front.

We find it interesting and potentially telling that the ECB’s decision, announced last Wednesday evening by Chief Economist Philip Lane, to adjust the staff forecast schedule so as to incorporate the Russian invasion, launched in the wee hours of February 24, also allowed the inclusion of the latest euro area inflation data, released March 2 and presumably not available to the ECB all that much earlier.

Did the ECB want to ensure it would dispose of an additional hawkish argument to mute the cries of doves to keep the throttle open?

While Panetta and others have advocated going slow in view of Moscow’s assault on Ukraine, euro area HICP will reinforce the sense of urgency about normalising policy. As both a raft of comments by ECB policymakers in recent weeks and the account of their February meeting make clear, this sentiment had been growing in the runup to Russia’s aggression.

On balance, we think the ECB would be quite loathe to seem to have fundamentally reconsidered and thus expect President Christine Lagarde to confirm not only the general direction, but the steps taken so far to get there, starting with the decision to terminate the pandemic emergency purchase programme (PEPP) this month; pandemic-related developments do not warrant its extension anyway.

However, the steps not yet taken may be subject to more critical review, though completely consistent with clearly enunciated principles.

To be sure, 2Q is nearly upon us, so sticking to a monthly net purchase pace under the asset purchase programme (APP) of €40 billion in the second quarter is reasonable, conditional of course on developments to come, as the ECB should stress. Beyond that, the ECB may want to be more ad hoc.

Therefore, without explicitly declaring any intention of buying less than €30 billion per month in 3Q and €20 billion per month thereafter, the ECB could opt for a reaffirmation of its intention to taper, but – in the name of optionality and flexibility – without being as precise as in December.

In general, the Governing Council may not want to make too many decisions, and Lagarde’s appearance before the press could be correspondingly short on specifics. Rather, she seems likely to point again and again to the uncertain, even volatile environment, the evolving situation, the ability of the ECB to take decisions at any time, its willingness to move in any direction called for including an increase in net asset purchases, and its data-dependent pursuit of financial and price stability.

As for interest rates, Lagarde wasn’t much inclined to discuss lift-off even before February 24. On Thursday, she will have less reason yet to allow herself to be pinned down, be it to rule in or to rule out any particular scenario. Queries are likely to be dismissed as premature.

We think the ECB has solid grounds for the widely speculated elimination of ‘shortly before’ from APP forward guidance and the words ‘or lower’ from guidance on interest rates, which would reinforce at low cost the idea that the ECB still sees normalisation ahead.

Though the forecasts will probably indicate the achievement of the ECB’s medium-term goal, or at least come within a hair of doing so, Lagarde may minimise this, arguing that forward guidance sets forth three conditions for raising borrowing costs – a point policymaker have repeatedly insisted on anyway - and that current circumstances make it well nigh impossible to assess the likelihood of all three being met.

She will argue as well that inflation expectations are in check, and that wage developments do not yet point to the sort of price spiral that the ECB would have to counter – and would of course counter unhesitatingly, she will say.

In essence, it is hard to see how the ECB could feel that it has the luxury in the current environment of sounding like much is on hold until such time, whenever that may be, as the dust settles. Having vaunted its optionality, gradualism, flexibility and data-dependence well before the current situation made the need for these so acute, the ECB is well positioned not to appear to be vacillating, but to be proceeding on course with the requisite caution in an ever more volatile environment.