ECB Insight: Amid Economic Weakness and Sagging Credit Demand, ECB to Favour Data-Dependence Over Hawkishness

25 July 2023

By David Barwick – FRANKFURT (Econostream) – Yet again, the principal outcome of the European Central Bank’s Governing Council meeting this Thursday seems beyond dispute, given the lack of any obviously adequate reason to backtrack from the 25bp rate hike consistently signalled over the last weeks. It thus once more comes down to how the ECB frames its attitude toward policy decisions ahead.


There is little chance of the ECB announcing that a deposit facility rate of 3.75% - or, probably, any other level, at the moment of it being reached - is the terminal rate; we suggested well before ECB President Christine Lagarde confirmed at Sintra a month ago that the final hike might, in our words, ‘only be apparent in the rearview mirror anyway.’


Nevertheless, at a certain level of interest rates, the ECB could deem it appropriate to indicate a tentative pause. Might this be the case at 3.75%?


Given still-strong inflation and the non-negligible number of hawkish policymakers who recently appeared warm to the idea of another move in September, this doesn’t seem to be the case yet, notwithstanding the latest evidence of economic weakening and ample confirmation via Tuesday’s Bank Lending Survey that rate hikes are weighing heavily on credit demand.


At the same time, the increasingly even balance between the likelihood of continuing to tighten and the likelihood of not doing so makes indicating a tentative hike in September seem very much like overreach.


At this stage, we therefore expect the ECB to play it safe and abstain from providing any explicit guidance. In principle, this should be entirely feasible: the ECB would simply need to adhere, rather than merely pay lip service, to the data-dependent, meeting-by-meeting mode it introduced some time ago.


Then the question is whether the ECB will, even as it takes care not to flag the next decision, nonetheless continue to lean towards further policy tightening (within limits, we don’t see this as necessarily inconsistent with the lack of more specific guidance).


We think the ECB is very uncertain as to whether it is going to hike in September (we suspect it won’t), so that President Christine Lagarde will wish to play down the idea of a hiking bias, if perhaps without rejecting it outright.


If asked directly, we would thus expect her to respond very guardedly and invoke data-dependence. To the extent she wants to convey the notion that the ECB remains open to hiking, it would be sufficient for her to recycle her own recent language, such as the warning on 7 July that although ‘inflation has started to decline’, it ‘is still higher than our medium-term target of 2% and according to our staff projections, is set to remain so in 2024 and 2025. We therefore still have work to do to bring it back down and reach our target.’


‘Work’ need not mean actual further hiking, but rather can also be understood to include maintaining rates at peak. That said, the example brings into clear relief the potential pitfalls Lagarde will need to skirt if she wants – again, as we expect – to avoid communicating an explicit hiking bias.


True, in that same interview she gave just over two weeks ago, Lagarde’s overall tone was more consistent with such a bias, as she cautioned that ‘[a] simultaneous increase in both [corporate margins and wages] would fuel inflation risks, and we would not stand idly by in the face of such risks.’


And looking around at the most recent comments of various other policymakers, we find it difficult to imagine that the Council would regard a September hike as so farfetched that it would want to play the possibility down too much.


That said, such a bias has become less pronounced, and accordingly, we expect Lagarde to sound less hawkish overall than on 7 July. The latest PMIs and the German Ifo index offer a basis on which to admit that the ECB’s June macroeconomic forecasts may have been unduly optimistic. The newest Bank Lending Survey resoudingly confirms the growing impact of previous rate hikes, and by itself should limit the hawkish upside risk on Thursday. That the recent survey of consumers showed expectations anchored is also worth mentioning.


Lagarde may take a cue from Vice President Luis de Guindos, who – also on 7 July – was already practising more dovish tones, observing that ‘policy tightening is increasingly feeding through to the real economy’ and that ‘the unusually high level of uncertainty around the downward trajectory of inflation over the medium term has started to ease somewhat.’


And at some point, it may be apt to note here, ‘level’ will have to cede to ‘duration’ as the main subject of discussion, though we don’t see how this could happen all at once if the terminal rate can only be identified in retrospect rather than real time.


Will the ECB retain a key concluding statement from recent announcements of policy decisions? We refer to this: ‘The Governing Council’s future decisions will ensure that the key ECB interest rates will be brought to levels sufficiently restrictive to achieve a timely return of inflation to the 2% medium-term target and will be kept at those levels for as long as necessary.’


Monetary authorities may reason that it implies too strongly at the current juncture (‘rates will be brought’) that tightening moves are still to come. Of course, a change may invite undesirably dovish speculation. We think on balance that the ECB will prefer to court the danger of a change now, but minimise the risk of being interpreted too dovishly with a rewrite generic enough to be just as good if the Council hikes again as whenever it really does reach the terminal rate.


On a last note, we expect no major decisions with respect to quantitative tightening or the ECB’s operational framework. The two issues are closely related, and notwithstanding Lagarde’s promise last December of a review of the operational framework ‘[b]y the end of 2023’, this appears to have been delayed. For the time being, modification of the corridor between the key ECB interest rates is thus also unlikely.