Don't fight the ECB

Comments by Franck Dixmier, Global CIO Fixed Income, AllianzGI, ahead of the European Central Bank meeting in March 2023.

ECB

• We expect a 50bp rate hike, as previously announced by Christine Lagarde 
• Faced with persistent underlying inflation and a resilient economy, the ECB should continue to tighten monetary policy
• The hike is widely anticipated by markets, which have given up their complacency about the potential for a rate hike

The outcome of the next European Central Bank (ECB) meeting is unlikely to be a surprise. ECB President Christine Lagarde has already announced a 50 basis points (bp) rate hike for March.

However, it will be interesting to listen to her indications about the decisions in the upcoming meetings, and the pace of future rate hikes (of 25bp or 50bp). The ECB remains under pressure as the fight against inflation is far from won. It is true that headline inflation decelerated to +8.5%[1] in February (from a peak of 10.6% in October 2022). But core inflation continued to rise to +5.6% in February, against a backdrop of resilient economic activity, particularly in services, as shown by the PMI index[2], registering 52.7 in February compared to 50.8 in January.

The risk of a more sustainable inflation than anticipated should lead the ECB to show even greater determination in the forthcoming monetary tightening. The ECB's reaction function should be dependent on economic data, considering three key parameters, as recently indicated by Philip Lane, its chief economist.

• The evolution of core inflation, which is still too high;
• The ECB's medium-term inflation expectations, which will be communicated at the meeting;
• The correct transmission of monetary policy. The latter remains difficult in a context of resilient employment and demand, which are stimulated in particular by fiscal policies in support of households.

The only comfort for the ECB is that, despite the upward surprises on actual inflation, inflation expectations are well anchored and oriented: medium-term household expectations are falling, with inflation expectations over the next 12 months at 4.9% [3]in January compared with 5.0% in December 22 and over three years at 2.5% in January compared with 3.0% in December. And the 5y5y inflation swap is at 2.42%[4], after a feverish surge to 2.60% in early March.

After a major recalibration of central bank rate expectations, the big lesson of February is the end of investor complacency. Faced with constant surprises, both on the resilience of activity and the continued rise in core inflation, the markets have capitulated. They now expect a terminal rate of between 3.75% and 4%.

The recent correction in rate hike expectations has been accompanied by a tightening of yields and a continuation of a marked inversion of the yield curve. The upcoming meeting should not contradict these recent movements. We expect a determined tone from the ECB, which cannot be content with core inflation’s rise.

Recent events should not influence the ECB's decision to raise rates by 50bp this week. However, the potential contagion of what is now an idiosyncratic risk should make the central bank cautious in terms of indicating further policy tightening and the extent of the hikes.

[1] Source: Eurostat, February 2022

[2] Source: S&P Global's final manufacturing Purchasing Managers' Index (PMI)

[3] Source : Consumer Expectations Survey, ECB

[4] Source: Bloomberg, 9 March 2023

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