La Française: Pre ECB commentary

8 juni 2022

By François Rimeu, Senior Strategist, La Française AM

Inflation at an all-time high. The ECB has no choice but to secure medium-term price stability.

The European Central Bank (ECB) will hold its quarterly press conference on June 9.  ECB Chair Lagarde has built a consensus for a gradual approach to policy normalization. The Committee will update its macro-economic projections with substantial inflation pressure and a deterioration of the growth outlook.

Please find below what we expect:

• As preannounced by Christine Lagarde, because of intensification of inflation pressures, the ECB is expected to announce the end of the asset purchase program (APP) at its June Governing Council meeting and a first-rate hike in the Deposit Facility rate (-0.50%) at its July meeting. The three conditions for hiking rates are met. It is also expected that Lagarde pre-signal the exit of negative rates by September.
• Chair Lagarde should underline that the pace of policy tightening will be data-dependent (i.e., domestic demand, underlying inflation, and financial conditions). We believe that the Governing Council will not exclude 50 basis points (bps) steps to move quickly nor rising the deposit rate significantly above neutral (1%-2%) as higher inflation is threatening to de-anchor inflation expectations.
• Regarding quantitative tightening, Chair Lagarde will most likely reiterate that it is premature. Interest rate hiking is the main monetary policy tool at this stage. But we believe that reducing the size of balance sheet will be the topic of debate moving forward, namely after the TLTRO (targeted longer-term refinancing operations) pay back announcement in mid-June.
• Lastly, Chair Lagarde is expected to reaffirm that the central bank could act swiftly to deploy new instruments to prevent market fragmentation that could be triggered by a tightening of the monetary stance. However, current spreads do not yet justify an announcement. We do not believe that the Governing Council will launch a new bond-buying program without offsetting any purchases by taking an equivalent amount of money out of circulation. Chair Lagarde will reinforce the importance of flexibility as normalization proceeds.
• On the economic front, we expect the ECB’s inflation projections to be revised significantly higher in 2022 (from 5.1% to 6.9%) and moderately in 2023 (from 2.1% to 2.3%). Inflation would then decline towards the 2% target at the end of the forecast horizon but with a high level of uncertainty. Regarding growth, projections should indicate lower figures in 2022 (from 3.7% to 2.8%) and 2023 (from 2.8% to 2.5%). A technical recession in the coming quarters should not be ruled out. For 2024, the upward revision will be marginal, from 1.6% to 1.7%.

In summary, maintaining credibility by defending its inflation target from high inflation is key for the ECB. Although the June Governing Council announcements will not come as a surprise given the ECB’s proactive communication, we believe risks are from the hawkish side (i.e., possibility for 50 bps rate hikes at the upcoming meetings, pushing rates into restrictive territory, early discussion around quantitative tightening).  Therefore, we expect some flattening on the euro swap curve.