ECB dovish, but market hawkish

She explained that the rise in inflation reflects two key factors (see full speech here). She noted that ‘inflation collapsed last year when lockdowns were imposed, which is creating strong base effects as activity recovers. Half of total inflation in the euro area today is due to energy prices, which are making up the lost ground from 2020. Base effects from last year’s German VAT rate cut and the unusual timing of sales periods are also playing a role’. In addition, ‘imbalances between demand and supply in some sectors are pushing prices up’. The ECB head referenced that ‘global supply chain disruptions (that) met a sharp recovery in demand for durable goods’ and ‘demand returning to the sectors hardest hit by the lockdowns’.

The ECB still appears to have a high conviction that inflation will fall back and end up below target over the medium term. Ms Lagarde noted that ‘once these pandemic-driven effects pass, we expect inflation to decline’ while ‘base effects should drop out of the year-on-year calculation early next year, although we are seeing further increases in oil and gas prices’. Although ‘it is harder to predict how long supply chain disruptions will last, but their ultimate impact on inflation will depend on how persistent they are and whether they feed through into higher than anticipated wage rises’. Here the ECB did not see reasons for concern. The ECB President explained that ‘we see no signs that this increase in inflation is becoming broad-based across the economy’ while ‘wage developments so far show no signs of significant second-round effects’ and ‘inflation expectations also do not point to risks of a prolonged overshooting’.

The policy implications of these views were also made clear. Ms Lagarde said the ECB would ‘not overreact to transitory supply shocks that have no bearing on the medium term’ while the ECB’s forward guidance ‘ensures that we will only react to improvements in headline inflation that we are confident are durable and reflected in underlying inflation dynamics’.

Markets pricing in more rate hikes despite dovish ECB inflation narrative

The ECB President’s comments seem to be falling on deaf ears for now. Indeed, we continued to see a sharp retracing of market ECB rate hike expectations today, which is pushing up Bund yields and steepening curves. This is a continuation of a trend that has been in place since the start of this month and markets are now pricing in more rate hikes than at the previous peak in May. We remain of the view that inflation will fall sharply next year and remain low over the medium term. Given the ECB’s forward guidance, this means that rate hikes are not on the cards in the coming years. Rate hike expectations and Bund yields should therefore eventually fall back. Having said this, with HICP inflation in the eurozone heading towards 4% in the final months of this year, these elevated short rate expectations (and hence Bund yields) may remain elevated into Q4. Though further out we expect these moves to unwind again as inflation falls and the ECB's forward guidance is reiterated.