ECB Watch - ECB has moved to a tightening bias

The Governing Council is now providing an explicit risk assessment on inflation, in wording similar to the run-up of its first rate hike in 2022. In its March press statement it noted that ‘the risks to the inflation outlook are tilted to the upside, especially in the near term’. In June 2022, when it first signalled a rate hike, it noted that ‘the risks surrounding inflation are primarily on the upside’, while in July of 2022, when the ECB actually hiked rates, it noted that ‘the risks to the inflation outlook continue to be on the upside and have intensified, particularly in the short term’.

Rate hikes are priced into the baseline

The ECB staff’s updated projections showed a significant upgrade to inflation – in 2026 to 2.6% from 1.9% in December – and a downgrade to growth, which is now 0.9% down from 1.2% in December. The baseline for inflation shows it returning to target in 2027 and essentially staying there. Even though there is a very slight overshoot in 2028 (2.1%), acting on that would be overly ‘fine-tuning’ in a way that the ECB dismissed last year when inflation was projected to undershoot the target. However, crucially, the inflation projection is already predicated on market pricing of some policy tightening (approximately 43bp by end 2026 as of the 11 March cut-off). This implies some modest tightening would be required for the forecast to be met.

Not wanting to add fuel to hawkish bets

Going into the meeting, the Governing Council was aware that rate hike expectations had risen further compared to the time it made the projections. Markets were expecting more than 50bp of hikes this year, and the ECB may not have wanted to encourage a further build-up of these expectations at this stage. In particular, the ECB may want to keep its options open for the April meeting given the uncertainty. Still, we think a rate hike by the June meeting is looking like an increasing possibility. We are reviewing our macro baseline and are publishing our updated forecasts next week.

Scenarios suggest extent of damage to infrastructure crucial

Perhaps more interesting than the projections were the alternative scenarios that the ECB presented: one ‘Adverse’, where energy prices jumped further from here but normalised by the end of the forecast horizon in 2028, and another ‘Severe’ scenario where prices spike even higher and stay relatively elevated. These alternative scenarios map fairly closely to our own ‘Middle’ and ‘Negative’ scenarios respectively, which we published last week (see here). A key element of the ‘Severe’ scenario is that it includes significant damage to energy infrastructure such that it takes longer for energy supply to fully normalise. This is a risk that is crystalising at present following yesterday’s attacks on South Pars gas field and Iran’s subsequent retaliation on Qatar’s LNG infrastructure (with Qatar Energy today claiming this would take 3-5 years to fully repair).

Severe scenario points to string of hikes

In the ECB’s Adverse scenario there appear to be limited second round effects on inflation, and even in the Severe scenario inflation falls back very close to the 2% target by the end of the horizon. However, core inflation in the Severe scenario is very elevated, holding around 4% for three quarters in the second half of 2027, and wage growth jumps 2pp to nearly 6% by end 2027. With these kinds of numbers, we think the Governing Council would be sufficiently worried about the risk of inflation expectations de-anchoring to embark on a string of rate hikes (perhaps three 25bp hikes), as we described in our negative scenario last week.

ECB will focus more on inflation than growth

Finally, in terms of growth, the ECB projects a more severe initial growth shock than we do in their alternative scenarios, with a single quarter contraction in the Adverse and a mild technical recession in the Severe scenario, but growth then bounces back to above the baseline implying a limited lasting impact from the energy shock. This is consistent with our assessment that the ECB would be minded to focus on the risks around the inflation outlook rather than growth, and therefore still be minded to tighten policy in the Severe scenario