Eurozone: The consequences of the ECB’s pivot

After the February Governing Council meeting, ECB President Lagarde sounded surprisingly hawkish. She signalled that the central bank will reduce policy accommodation this year. The central bank probably was spooked by the upward surprise in the inflation data for January (5.1%). Indeed, the core inflation rate did not decline as much as expected, which may have supported the view that underlying inflation was starting to firm. Moreover, the ECB seems to be becoming more confident that wage growth will rise this year. As a result of the ECB’s pivot, we have changed our forecasts. We think that a tapering of the APP will be announced in March, with net purchases ending altogether in September. We have also pencilled in a 10bp deposit rate hike in December of this year and an additional one in March of next year. After that, we expect rate hikes to be aborted, or at least put on ice, with the deposit rate at -0.3% by the end of 2023. Having said that, there is a non-negligible probability that the window of opportunity for a rate hike might close before the end of the year, mainly because the inflation rate is expected to drop lower in the final months of the year, financial conditions will be tightening on the back of aggressive Fed rate hikes, and economic growth is expected to come in below current ECB expectations.

The changes in our ECB policy forecasts have led us to revise our estimates for short term interest rates, government bond yields and the euro/dollar exchange rate upward. The resulting tightening of financial conditions probably will not be strong enough to choke off the economic recovery, but it should reduce the pace of growth somewhat. Therefore, we expect GDP growth to slow down to the trend rate in the course of 2023, whereas we previously expected it to remain above the trend rate. Initially, we expect modest growth in 2022Q1 and a sharp rebound in 2022Q2-Q3 as Omicron related disturbances to services sector activity and global supply chain problems will hurt in the first months of this year, but will subsequently ease. A more normal cyclical growth pattern should take shape from the final quarter of this year onward.

With regard to inflation, we have sharply raised our forecasts for the first half of this year, mainly due to higher food and energy price inflation. Indeed, rises in energy commodity prices filter through into household energy prices with a significant delay, keeping energy price inflation elevated for a while. We expect some of the higher energy price inflation to filter through into some parts of core inflation, but this should be more than compensated by the downward impact of further normalisation of the inflation rate of holiday and entertainment related services. Sharp downward base effects in energy price inflation should push headline inflation well below the ECB’s 2%-target in the final months of this year. Meanwhile, wage growth at the eurozone level is still subdued. It is expected to strengthen during this year and next, but the impact on underlying inflation should be buffered by rises in labour productivity.