By Carsten Brzeski
The ECB is another example of a central bank that has been completely overwhelmed by inflation dynamics and a paradigm shift of major central bankers. Let us recall that not so long ago that the ECB ruled out the possibility of even a small rate hike in 2022. Then there was the gradual and measured approach to rate hikes which was replaced by a surprise rate hike of 50 basis points in July. We are now on the so-called meeting-by-meeting approach (MBM and not MiB). This is an approach that clearly makes more sense and should have been introduced much earlier, as it would have prevented the ECB from making the communication errors described. But the MBM approach is also an approach that opens the door wide to speculation and volatility, because it makes it more difficult to read the ECB’s reaction function.
Paradigm shift and the search for the reaction function of the ECB
And exactly this reaction function has changed. This follows a paradigm shift by many central banks, as recently witnessed at the Jackson Hole symposium. A paradigm shift that is characterized by central banks trying to break inflation, accepting the potential costs of pushing economies further into recession. It’s similar to what we had in the early 1980s. Back then, rising inflation was also mainly a supply-side phenomenon, but eventually led to price-wage spirals, and banks central banks had to raise policy rates to double-digit levels in order to bring down inflation. With the current paradigm shift, central banks are trying to get a head start – at least one step ahead of the curve of the 1970s and 1980s.
Whether the central bankers’ paradigm shift is the right one or simply that there are too many good things is another question. What is striking is that central bankers have implicitly moved away from measuring the impact of their policies by variables and medium-term expectations to measuring it by current and actual inflation results. This could certainly lead to policy rate overruns and post-policy mistakes.
Back to the ECB. As headline inflation hits a new high and wholesale energy prices continue to be elevated for consumers and businesses in the months ahead, many ECB officials have sounded the alarm. . In Jackson Hole, Isabel Schnabel gave a very hawkish speech, calling for an aggressive rise in interest rates to prevent inflation expectations from becoming unanchored or a price-wage spiral from being triggered. “Caution,” Schnabel said, was not the right remedy. to deal with current supply shocks. Instead, she called for a “strong” response, even at the risk of weaker growth and higher unemployment. Other ECB members followed suit, calling for a 75 basis point rate hike next week. Some have explicitly pleaded to bring the key rate above its neutral level. Only ECB chief economist Philip Lane took a slightly different stance, calling for a step-by-step approach.
Intention of aggressive rate hikes – but will that help?
We are still struggling to see how aggressive rate hikes can lower headline inflation in the Eurozone. The economy is far from overheating and will almost inevitably fall into a winter recession, even without further rate hikes. In such a situation, the gradual normalization of monetary policy makes sense, trying to break supply-side inflation with rate hikes, however, indeed resembles this idea of ”if you only have a hammer, everything must be treated as if it were a nail”. Admittedly, the situation is difficult for the ECB: showing its determination to bring down inflation would easily be interpreted as panic.
To better identify the ECB’s reaction function, we will be closely watching the latest staff projections, which will also be released next week. Two things will be important: how negative or positive will the ECB be on the Eurozone growth outlook for the winter, and what are the inflation projections for 2024. Recall that in June, the ECB still forecast GDP growth of 2.1%, which is far from our own forecast of -0.6%. Regarding 2024 inflation, the June projections showed annual inflation of 2.1%. The more downgrades we have to both projections, the less likely the suggested aggressive rate hikes will be.
Walking through a recession is not the same as walking through a recession
In any case, and even though the doves of the ECB have been very quiet in recent weeks, we expect the ECB to go up “only” 50 bps next week. It would be a compromise, leaving the door open to further rate hikes. 75bp seems a bridge too far for doves but cannot be ruled out entirely. Further down the road, we may see the ECB rise another time at the October meeting, but struggle to see the ECB continue to rise when the Eurozone economy is hit by a winter recession. Walking into a recession is one thing, walking through a recession is another.
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