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ECB Preview – Inflation Forces the Normalisation Process to Continue

  • A difficult ECB meeting is due to take place on Thursday next week. After the pivotal hawkish communication shift at the February meeting, the ECB will have to balance a stronger inflation outlook with the highly uncertain economic impact of the Ukraine-Russia war.
  • We expect the ECB to continue its path towards entering a ‘neutral’ monetary policy calibration and formally set an end date for the APP programme (in September this year), due to the high inflation pressure, but fall short of giving a firm indication of an upcoming rate hike. We expect the ECB to remove the ‘or lower’ wording from the forward rates guidance and give no time indication between the end of APP and the first rate hike, by removing ‘shortly before’ from its decision statement.
  • The staff projections are likely to contain exceptional uncertainties given the implications of the Ukraine-Russia war are not yet known. We expect the staff projections will point to 2% core inflation in 2023 and 2024, allowing the policy normalisation process to continue.
  • We acknowledge there is a risk of our expected ‘continuation of normalisation’ process view only coming at a later stage, as it may be a politically difficult decision to tighten monetary policy with a war on the continent. However, we expect the high underlying inflation pressure to prevail in the discussion (especially after February’s core inflation of 2.7% y/y, 0.4% m/m sa), despite the weaker growth outlook.
  • The ECB is attentive to financial stability and may launch a 1y LTRO operation already in March 2022. We expect a formal end to the TLTRO discount to be set for June 2022, as widely expected.
  • We think markets may be in for a hawkish surprise initially, but for now we find the 27bp priced for a December hike this year as fair from a risk/reward perspective.

Resilient economic backdrop with uncertainty due to war…

Russia’s aggression in Ukraine is an unpleasant source of uncertainty for a central bank and particularly after the ECB’s hawkish pivot at the February meeting, clearly raising expectations for policy tightening ahead. The stronger-than-expected economic backdrop and tight labour markets with high and more persistent inflation pressures should – all else being equal – make the ECB fairly confident that a gradual and flexible approach to monetary policy normalisation is needed. However, stressing a highly data-dependent stance with optionality will remain crucial in our view.

…but high inflation to keep pressure on ECB to start policy exit

It will be a difficult communication exercise awaiting the ECB at the March meeting. The economy rebounded at the turn of the year as fading Omicron headwinds and easing supply chain stress underpinned services and manufacturing activity. The labour market recovery also continued at a rapid pace, with the unemployment rate falling to a new all-time low of 6.8% in January and labour force participation standing above pre-crisis levels.

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