ECB Insight: A Pause May Make More Sense, But Updated Forecasts Could Interfere

13 September 2023

By David Barwick – FRANKFURT (Econostream) – In the run-up to the September 2022 monetary policy meeting of the European Central Bank’s Governing Council, we surmised with respect to the outcome that available evidence pointed to a 75bp hike ‘as a bit more probable on the basis of the number of supporters and the feebleness of the pushback.’

A year later, we can express ourselves with regard to the option of a pause this week in somewhat the same way, with the important caveat that our uncertainty is so high this time that neither would a hike really surprise us.

Still, we favour a pause. Our review of where individual Governing Council members stand is less of a reason for this, even if the number of those probably more amenable to pausing is slightly higher than the opposite faction.

The fact that the tally doesn’t weigh more heavily in our considerations is because the largest group of Council members is actually those whose position is unclear, underscoring the need to treat any speculation with caution.

Our reasons for deeming a pause more likely are thus the following:

• Notwithstanding the clamour of the hawks, they sound relatively willing to accept a pause. Peter Kažimír has come out more explicitly than almost any of his peers in support of more tightening, and yet in a comment last week on the website of the National Bank of Slovakia, which he heads, he readily conceded that one possibility was pausing in September and then hiking again next month or at the end of the year. The option of hiking now was the ‘preferable, reasonable’ option, and were the ECB to go that route, ‘I certainly won’t object’, he said. The contrast with his ‘we need to deliver another rate hike in July’ rhetoric following the June Council meeting is clear. Other examples can be found in our compendium of policymakers’ recent comments.
• The arguments expressed by the hawks to date have been unconvincing, and we think the doves on the Council also aren’t impressed. That applies most of all to the idea that September is the last chance to hike before economic weakness becomes too pronounced to admit a hike. If a looming slowdown in activity is seen as likely to dampen inflation to an extent inconsistent with more tightening, then this should be an argument to pause. But the following lines of reasoning we don’t see as much better; they sound more akin to grasping at straws:
  • Kažimír: 25bp in September would be ‘a more straightforward and efficient solution. Markets receive a clearer indication about the likely terminal rate, and we have more time to evaluate whether inflation is on a sustainable downward path towards our target.’
  • Robert Holzmann (Austrian National Bank): ‘It’s better to achieve a peak rate faster, which also means we can eventually start going lower earlier. It’s more difficult for markets to digest a stop-and-go rate path.’
  • Mārtiņš Kazāks (Latvijas Banka): ‘We can cut rates if we raise them too much and we can cut quite soon. But if we've done too little, then we may have to raise them even more, so it's cheaper to do it sooner than later.’
• Compared to the macroeconomic forecasts issued in June, inflation has been more or less as expected, whereas output has been weaker than anticipated. True, one could have preferred more unambiguous readings for August euro area HICP or for July’s consumer expectations survey, but overall, the data of recent weeks have arguably failed to make clear why another rate hike would be preferred when pausing was considered an option. This is no more than ECB Vice President Luis de Guindos said two weeks ago, when he observed that ‘what we were identifying as potential downward risks for economic growth have been taking shape, that is, the indicators that we have been seeing in July and August and the leading activity indicators point to a slowdown in economic activity in the third quarter and probably also … in the fourth quarter. … the services have also begun … to show weakness. That should ultimately lead to a slowdown in inflation.’
• We assume the ECB deemed it appropriate to introduce in July in good faith the option of pausing in September because it had ceased to be clear six weeks ahead of time ‘whether and how much ground we have to cover’, as President Christine Lagarde said then. With this question likely to remain shrouded in uncertainty, hiking now and hoping that this will turn out to have been a good guess strikes us as downright silly, given the ECB had the foresight to prepare the lower-cost option of pausing and then hiking later, if need be. After all, in which cases did the ECB see itself in July as potentially wishing to pause in September? One case would be if developments had deviated from expectations in a way that made clear that a new hike was not needed. But this was always the less likely event, as it would imply a situation counter to that embodied in the forecasts. Ergo, the present case, in which it would behoove uncertain policymakers to wait and see how the situation evolves further, would seem to be the chief one for which a hawkish pause was tailored.
• We see an increased awareness on monetary authorities’ part that, as relatively hawkish Executive Board member Isabel Schnabel recently noted, ‘[t]he lagged effect of past policy rate increases implies that monetary policy will continue to dampen aggregate spending.’ Bundesbank President Joachim Nagel, no less a hawk, also conceded late last month that ‘the most effects [of previous tightening] we will see next year’.

A pause, accompanied by hawkish messaging, thus seems to us the more logical step in the absence of anything but high confidence that another hike is needed now, and we don’t see what such confidence is likely to be based on.

There is however a large ‘but’ to all this, which is why we are far from taking a pause for granted, despite having voiced the suspicion as early as 25 July that the ECB would not hike in September.

One qualification to our central scenario of a pause is that, as noted above, the unclear group represents a plurality of Governing Council members. They have played their cards laudably close to their chest in public and private, awaiting all relevant data.

Sincere in their open-minded data-dependence as they may be, a substantial majority of those in the group have tended to align with the hawks over the course of the current tightening cycle. Will the data give them a reason to do so again? Possibly, and this is our second qualification.

This is because, given the ECB’s mechanistic use of prevailing futures prices in its macroeconomic forecast exercise, the recent increase in energy prices could boost the HICP projections for the current year and 2024, though not necessarily 2025.

True, weaker activity should limit the upside, but the ECB’s keen desire to avoid returning to the days of systematically underestimating inflation could also limit the downside.

And whilst the idea that the monetary policy should respond to every vicissitude of oil prices is flawed, under current circumstances, with the anchoring of expectations a priority, sharply more expensive energy may play into the hands of those Council members already inclined towards one last hike, and could allow them to garner the necessary support for this to be the outcome.

Though we still think a pause in tandem with hawkish messaging makes more sense, we can only echo the words of an ECB insider who, with only days left to the meeting, said that ‘the decision is going to be very tight and is very uncertain at this moment.’

As an aside, we don’t think any substantive change to the pace of quantitative tightening is likely to emerge, though we don’t exclude indications of openness to discussing it in the near term.