The ECB’s uphill struggle to temper rate hike expectations

Over the last few months, market expectations of ECB rate hikes have been scaled up in line with rising inflation expectations. The ECB’s Chief Economist Philip Lane has taken exception to markets building their rate hike bets. Last week he asserted that it was challenging to reconcile ‘market pricing of the forward interest rate curve…with our pretty clear rate forward guidance’. He also pointed out that ‘various Governing Council members have been indicating (that) markets may not have fully absorbed rate forward guidance’. This could be a message we hear repeated in the ECB press conference on Thursday.The ECB’s forward guidance on policy rates is conditional on the inflation outlook. It notes that ‘the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. This may also imply a transitory period in which inflation is moderately above target’. It was later clarified that ‘well ahead of the end of its projection horizon’ meant a 12-18 month period. So ostensibly, inflation would need to be projected at 2% in 12-18 months, while remaining around that level for the rest of the forecasting horizon. The ECB Staff’s latest inflation projection sees inflation at 1.6% at the very end of 2023, while it is rising at a very slow pace leading up to that, suggesting it may not reach 2% until beyond 2025. That would make rate hikes over the coming years unlikely, assuming of course that the ECB’s judgement on the outlook for inflation over the medium term is broadly correct. Currently, markets are pricing in a substantial rate hike cycle starting at the end of 2022. This points to investor doubts about the credibility of the forward guidance and/or the view that inflation will come in higher than the ECB expects. Indeed, inflation expectations according to the 5y5y inflation swap rate have surged through the 2% level recently to the highest levels seen since 2014. The big question of course is whether the ECB will succeed in pouring cold water on market expectations for early policy rate hikes. This might prove very challenging at the November meeting as ECB President Lagarde will have little other than words to try and shift expectations. The December Governing Council meeting holds better prospects. First of all, although the ECB will likely announce the end of the PEPP at that meeting, it will also provide greater clarity with regards the future of the APP. The announcement of a long period of asset purchases under the APP would serve to re-enforce the forward guidance on policy rates because it is well understood that policy rates would not go up before asset purchases end. Second, in December, the ECB will publish new inflation projections, and a continued subdued forecast for the medium term outlook would also help to underpin the ECB’s message. Ultimately however, the proof of the pudding might be in the eating. We expect headline inflation to fall sharply from the start of next year and this is also likely to reshape market expectations of the timing of a rate hike cycle. We remain of the view that policy rate hikes are unlikely in the coming years.