The Done Deal

25 October 2022

By David Barwick – FRANKFURT (Econostream) – Just as it surprised on the hawkish side in July, the European Central Bank’s normalisation of policy may eventually include a surprise on the dovish side. While we rate the chances of this in October a tad higher than most observers seem to, we don’t think it will occur now.

We would be similarly inclined to exclude a hawkish surprise, i.e. a 100bp hike, meaning that in the end, we, like pretty much everyone else, anticipate a hike of 75bp – the ‘done deal’.

Our reason to rank this the most probable outcome is that so many policymakers have expressed themselves accordingly, and data to date justify hawkishness. We are less swayed by market expectations, keeping in mind that one ECB insider told us just in the last few days that monetary authorities ‘don’t care what the market is expecting.’

‘The decision will be based on the comprehensive assessment of the indicators and in particular inflation, but also inflation expectations’, this person insisted. ‘If we have to surprise the market we will do it in either way, on the upside or on the downside.’

Looking at the indicators, although September HICP was revised down marginally from the initial estimate to 9.9%, the final reading remains a record high and keeps quarterly inflation clearly above what the ECB had projected. Assuming no reason for complacency is found in the latest Survey of Professional Forecasters, then arguments in favour of 75bp scarcely need depend on a reluctance to disappoint market expectations.

But to the extent market expectations do figure, and given the ECB attaches high importance to the signalling effect of its actions, then what financial markets think may matter more than usual, i.e. the ECB may in fact care, though the signalling effect is meant to be heard not only by markets, but also by price- and wage-setters.

Still, it is not all that cut and dried, perhaps.

‘The September inflation figure was higher than we expected, so the surprise is on the upside’, the aforementioned insider noted. ‘But in the last few weeks, the surprise in the energy prices has been on the downside … so I’m pretty sure that there are going to be people arguing why don’t we move by 50 basis points now, because to some extent some inflation dynamics could be mitigating, and there are some risks coming from Germany specifically in terms of economic activity that will depress inflation.’

None of this rules out a unanimous decision in favour of 75bp, but the above is worth keeping in mind, perhaps less so now though than in December, when the ECB might be in a better position to offset a dovish surprise with communication on quantitative tightening, for example.

On other key aspects of the policy meeting and subsequent press conference, our thinking is as follows:

• On TLTROs, whilst aware of rumours that the Eurotower is now comfortable with a retroactive change of the conditions despite known concerns, the ECB can be inventive, and we can imagine this occasion motivating a resourceful solution rather than one conceptually simple but fraught with avoidable problems. Whatever measure it opts for, we see a chance that the Governing Council will take a somewhat cautious approach in acknowledgment of the fact that the economic slowdown likely already underway suggests that banks may face stormier seas ahead.

• On growth and inflation, ECB President Christine Lagarde will probably characterise recent developments as somewhat in line with the ECB’s downside scenario in September in terms of growth, though inconsistent with respect to key commodity prices. While taking care not to sound too dovish on inflation, she is likely to note in this context that notable items have cheapened, gas quite significantly, and could observe that the impact of Nord Stream’s rupture one month ago has been only limited, thanks to substitution efforts. She could note prospects of slower inflation from the beginning of next year, barring new shocks, but qualify any such statement by observing that uncertainty remains high. She is apt to note the ongoing war, the weakening of confidence and the effect of simultaneous monetary policy tightening in multiple jurisdictions, but will remain disinclined to endorse the idea that softer euro area demand could do the ECB’s price stability job for it.

• Lagarde is unlikely to specify the neutral rate, the usefulness of which concept in real time the ECB is sceptical about, or the terminal rate, which is surrounded by great uncertainty, which changes with other macroeconomic variables, and which, if specified ex ante, might imply a commitment inconsistent with the current meeting-by-meeting approach. She is more likely to rely on her September suggestion to ‘leave it to you to decide whether it's going to be two, three or four’ more policy meetings to bring price stability back within reach. She may well no longer speak of frontloading, but if she does, it is not excluded that she would hint that the practice can henceforth be abandoned and/or indicate that moving in smaller increments might now be appropriate.

• On quantitative tightening, it is time for Lagarde to confirm that it is a subject of discussion at the level of the Governing Council, in which context she may emphasise the ECB’s attachment to the defined sequence in which the normalisation of interest rates enjoys priority. The ECB is unlikely to start QT and may neither identify a definitive starting date – beyond ‘early next year’ or the like - nor confirm the order in which different parts of the balance sheet will be unwound. Lagarde could however suggest that December might bring more clarity about these questions.

• On the corridor between the key interest rates, which we mention only because at least one analyst suspects this will be on the Council’s agenda this month, we think this is simply not yet seen as particularly relevant, given that the ECB expects the situation of considerable excess reserves to persist for some time, meaning that the pertinent rate remains the deposit facility rate and altering the corridor at this point would have no first-order impact on any relevant macro variable. We consider the issue best saved for an eventual discussion of, and decision on, the operational framework.