ECB set for hawkish pivot

Introduction

The ECB Governing Council meets next week against the background of the major energy shock that has arisen due to the conflict in the Middle East. The last few meetings have been relatively uneventful as with interest rates around neutral, growth seen around trend, and inflation expected to settle at target over the medium term, the Council had concluded that policy was in a ‘good place’. However, the energy shock is a clear challenge to that view. In this note we preview the upcoming meeting, where the ECB will also present updated macroeconomic projections.

The March projections

The ECB presents updated staff macroeconomic projections at its March meeting. The technical assumptions underlying the projections are typically based on futures curves. At the time of the December meeting, oil and gas futures were pointing to much lower prices than we are seeing currently. For instance, oil prices were assumed to be just above USD 60 per barrel (now around 100) and gas prices were assumed to be around EUR 30 MWh (now 50). Having said that, the ECB’s cut-off date for the projections is typically around three weeks before publication, which may leave the cut-off just before the conflict started, when risk premiums had started to build (oil around 73 and gas around 32). So the new projections will only modestly capture the impact of the energy shock and the baseline would therefore not show a very large jump in the inflation projection.

However, the ECB will also likely present scenarios for how the conflict will develop, some of which will assume energy prices closer to current levels or even higher. The higher energy scenarios are likely to show the ECB’s target being breached over the policy-relevant horizon, and therefore signal that they may need to act under more negative conflict/energy supply scenarios. In order to get a better sense of what the ECB’s projections and scenarios may show, we present two inflation scenarios above. One based on energy futures curves just before the first strikes (27 February) and one based on today’s futures curve (see chart above on the left). We do not include the impact of market pricing of rate increases, in order to better display what the ECB’s reaction function would be. As can be seen, the ECB’s likely March projection based on the just-before-war futures would show a slight over-shoot of the target. However, a projection based on current energy futures prices would likely show inflation over-shooting the target more significantly, especially factoring in some second round effects on core inflation.

What about the growth forecast? Although the ECB would likely show a negative growth impact in a higher energy price scenario, we expect this impact to be relatively contained. For instance, in our ‘middle’ scenario (see here) where energy prices hold at current or somewhat higher levels, we expect growth to slow to somewhat below trend for a time but then recover back to trend later in the horizon. Even in a more negative scenario, growth would go well below trend for a time, but the impact is likely to be much less than during the 2022-23 energy crisis, when the economy stagnated for 5 quarters. Given this, the worry of Governing Council members is expected to focus largely on inflation in our view.

A more hawkish tone, helped by a weaker euro

Given the projection on current futures curves, we would expect the Governing Council to strike a clearly more hawkish tone, while also stressing the high level of uncertainty on how the situation in the Middle East and hence energy supply will develop. The tone in recent official remarks has shifted. For instance, ECB President Lagarde asserted on 10 March that ‘we will do all that is necessary to ensure inflation is under control and French and Europeans don’t suffer the same inflation increases like those we saw in 2022 and 2023’. The commentary – as might be expected – has been more stark from some of the more hawkish officials. Joachim Nagel – the Bundesbank President – stressed on 11 March that ‘If it becomes apparent that the current energy price increases will translate into broad consumer price inflation in the medium term, the Governing Council of the ECB will act decisively in a timely manner’. Peter Kažimír, Governor of the central bank of Slovakia said on 11 March that ‘a reaction by the ECB is potentially closer than many people think. I don’t want to speculate about April or June. But we will be ready to act if needed’. While Executive Board member Isabel Schnabel warned on 6 March that ‘we need to be vigilant as the current geopolitical and macroeconomic environment creates upside risks to inflation over the policy-relevant horizon’. The response from the more centrist/dovish members has not really fought back in the other direction, but has more signalled that March is too early for a move.

Note also that the recent weakening of the euro accentuates the impact of higher oil prices on inflation, and given that the current exchange rate is based on market pricing of ECB rate hikes (see below), this likely gives additional room for the communication at the March meeting to strike a more hawkish tone than it otherwise would.

April could be a live meeting

Dut to the uncertainty on the conflict we are not changing our base case for now, which is that the ECB remains on hold for the foreseeable future. However, if the current conflict persists and/or energy futures curves remain elevated through to the 30 April meeting, a hike becomes a distinct possibility at that time. The ECB would be facing a medium-term inflation overshoot and would be keen to anchor inflation expectations. In addition, in terms of lessons learnt from the Russia energy crisis, most officials judge that they may have been too slow to respond, even though we note that there are clear differences from that situation in the sense that the gas price shock was bigger and the supply side of the economy was still recovering following the pandemic. We will be re-assessing our base case following the March meeting as well as based on incoming information. At the time of writing, a rate hike was priced in fully only for the July Governing Council meeting, while there was around 9bp of rate hikes priced in for April. So a more hawkish tone in March, could see markets pricing in a greater probability of an April move.