ECB Insight: Are Markets Misunderstanding the ECB? Maybe Just a Bit

18 October 2024

By David Barwick – FRANKFURT (Econostream) – Financial markets, we suspect, are seeing the European Central Bank Governing Council’s decision on Thursday a tad too strongly through the prism of wishful thinking.

Markets currently see at least a 25bp rate cut at each of the coming few meetings, with a more than 30% chance of a 50bp move priced in for the next gathering on 12 December.

Admittedly, the ECB set the stage for the misperception that may dominate markets’ view of where euro area monetary policy is heading. After all, an important catalyst seems to have been the rewording of a particular sentence of the monetary policy statement.

‘Inflation is expected to rise in the coming months, before declining to target in the course of next year’, yesterday’s statement read.

It is natural to compare that with the phrasing of 12 September, which agreed that inflation would rise again in the fourth quarter but went on to say that it ‘should then decline towards our target over the second half of next year.’

The updated projections made this more precise, showing ‘a return to 2% at the end of 2025’, as ECB President Christine Lagarde said at the press conference five weeks ago.

The assumption seems to be that if Lagarde now chose to say merely ‘in the course of next year’ rather than ‘at the end of 2025’, this implicitly amounted to a new inflation projection sufficiently more favourable than the previous one to motivate an accelerated pace of monetary easing.

While it is obvious that increased confidence in the disinflation process – which drove yesterday’s decision to cut rates – would be inconsistent with a worsening of the prognosis for restoring price stability, we would caution against any overinterpretation that Council members themselves are not engaging in.

We note that even while confirming in a statement today that ‘we should reach our 2% target earlier than expected in 2025’, Council member François Villeroy de Galhau did not hazard a guess as to how much earlier the new date would be, and assessed the risks of overshooting and undershooting the target as no more than balanced.

If anything, that might display more caution than his comments on 7 October, when he cited probabilities derived from the options market to suggest a greater risk of undershooting.

It may be more useful to think of the new wording of the monetary policy statement – ‘in the course of next year’ – as a bit of a placeholder, pending the next projection exercise, and to reserve judgment as to whether or not the improvement, if indeed it turns out to be sustainable, is so substantial as to warrant an increase in the pace of easing.

A possible overreaction by markets was further encouraged by the revelation – which surprised us - that the decision to cut rates had been unanimous. One would be well advised however not to succumb to the impression that all members of the Governing Council were equally enthusiastic about further easing; this was not the case.

Rather, it is just a fact that members of the Council do not necessarily indulge in putting up symbolic resistance after it has become clear what the decision is going to be. ECB policymakers thus sometimes lend their official support to decisions that are not the outcome they would have preferred, while continuing to express reservations in private after the fact.

In the present case, those Council members sceptical of the wisdom of easing again so soon were convinced by risk management arguments – better to take the chance of cutting unnecessarily than of not cutting when it might turn out to have been necessary.

Importantly, it follows from this that if the cut turns out to have been unnecessary, then that would call into question the need for a December cut. There will be some Council members who clearly understand this to be the case, but whether it is or not does not depend on what markets think inflation will actually do.

The complete reluctance of Lagarde to flirt with any possible subsequent rate decision should thus not have been read as a the-sky’s-the-limit invitation to financial markets to fantasise. It was, however; hence the thoughts of 50bp.

Ideally, Lagarde would have made clear that she was not encouraging such an interpretation. That is, erring on the side of slight hawkishness, as we expected and as would have been all the more appropriate given the nominal ‘unanimity’ of the decision, would have been called for.

As it was, this would have amounted to a certain retreat from the utter neutrality of the ECB’s data-dependent, meeting-by-meeting approach, about which she was as absolutist as ever on Thursday.

‘As I said, I did not open the door to anything’, she said. ‘I repeated that at each and every meeting we will look at the data.’

Some market participants appear to have put their own spin on this. They might want to lower their sights for the moment.