How the ECB was shocked to change its position on inflation

Economy News

A surge in eurozone inflation changed this week’s meeting of the European Central Bank’s governing body from what is expected to be an unremarkable event in a turning point for the bloc’s monetary policy.

The shift to a more “falcon-like” stance came amid January’s record eurozone inflation rate, which was announced on Wednesday shortly before the start of a two-day virtual meeting, according to five people involved.

The rise has apparently frightened many of the ECB’s councilors who until recent days believed the rise in prices in the last six months of 2021 was “transient” and would fade quickly this year, not least because of Germany’s inflationary effects. its temporary sales tax cut would have dropped from the data.

Instead of declining, however, inflation rose further above the ECB’s 2 per cent target for the seventh consecutive month to set a new eurozone record of 5.1 per cent. While about half of this was due to double-digit increases in energy costs, price pressures have also increased: the cost of six out of 10 items in the basket used to calculate inflation has risen over the past year.

Line chart of harmonized index of consumer prices (annual% change) showing that inflation has jumped far above the ECB's target

This led ECB policy makers to agree that their president Christine Lagarde should use the press conference after his Thursday meeting to indicate a likely U-turn. The best way to do that, they decided, was to stop rejecting the idea of ​​a rate hike this year.

Lagarde’s subsequent remarks, including her remarks that inflation risks have been “tilted to the top” and that it “comes much closer to the target”, have led to a sell-off in bond markets and a surge in the euro – which is crucial of moving.

The second factor behind the central bank’s shift was the rapid recovery of the pandemic’s labor market. It was brought home for ECB policymakers on Tuesday when Eurostat said eurozone unemployment had fallen to a record low of 7 per cent, mainly due to a fall in youth unemployment to an overall low of 14.9 per cent.

Further evidence of the recovery of the labor market came from the European Commission, which a few days earlier revealed that record numbers of both manufacturing and service companies were complaining about worker shortages. Wage growth in Europe remains below that of the US and the UK, but board members seem increasingly convinced that it will increase this year.

The ECB said on Friday that after a survey of 74 non-financial corporations in January found “they expect average wage increases of around 2 per cent in the recent past to move to 3 per cent or possibly more this year”.

Line graph of% of businesses reporting labor as a factor limiting output, showing that Eurozone businesses face unprecedented labor shortages

The last factor that convinced the remaining “pigeons” on the ECB board to reconsider their position came when US Federal Reserve Chairman Jay Powell caused a sell-off in the stock market last week by refusing to be more aggressive. exclude interest rate hikes this year than markets expected. . Furthermore, all the signs indicated that the Bank of England on Thursday raised rates for a second time in three months – as it did properly.

Lagarde was quick to point out that the eurozone is in a very different place from both the US, where a large fiscal stimulus has driven demand far above pre-pandemic levels, and the UK, where Brexit is putting pressure on strengthened and propelled the labor market. wages increase.

However, the “falconry” policy shift by both the Fed and the BoE ran the risk of making the ECB look like “the last pigeon standing” – as Allianz economist Katharina Utermöhl described it this week. One ECB adviser said the policy was more stringent “for credibility reasons, not fundamental reasons”. But others said there was a widespread feeling that the Fed and the BoE were behind the inflation curve and that the ECB did not want to end up in the same difficult position.

So where does that leave the ECB? Several of the more conservative “hawks” on the board spoke out in favor of Thursday’s meeting in favor of clearly communicating plans for an accelerated end to bond purchases, which should be a “step-by-step” reduction this year. , but still an open – ended timeline.

However, the “hawks” have finally agreed to wait until the ECB’s next policy meeting in March, when it is likely to raise its inflation forecast above 2 per cent for the next two years – and meet a key condition for it to finally raise rates.

One of those who called for a change in policy to be announced more quickly was Joachim Nagel, the new Bundesbank president, although a spokesman for Germany’s central bank said he was “very happy” with Thursday’s result. meeting.

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An additional factor complicating the ECB’s position is the growing tensions between Russia and Ukraine. If Russia invades its neighbor, energy costs are likely to rise further, but if tensions ease, prices could fall. The issue was briefly discussed at this week’s meeting, but most ECB policy makers feel powerless to either predict how the saga will end or to influence energy prices.

In response to Lagarde’s press conference, traders increased their bets on higher interest rates in the euro area, with markets pricing several increases in the ECB deposit rate from minus 0.5 per cent to minus 0.1 per cent by December.

However, most councilors think it is too aggressive. Even more “hawkish” central bank officials dismiss the idea of ​​a rate hike this summer as “ridiculous” and say the earliest it is likely to happen is the fourth quarter.

This would mean that the ECB remains behind the Fed and BoE in the stricter policy of combating high inflation. But given that the last time the ECB raised rates on the eve of the eurozone’s sovereign debt crisis in 2011, most board members seem comfortable with taking a more cautious approach this time around.

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