The ECB is under pressure

Comments by Franck Dixmier, Global CIO Fixed Income at AllianzGI, ahead of the ECB meeting on 14 April 2022?

Key Takeaways:

• Faced with historically high levels of inflation, the European Central Bank is expected to make a clear announcement of a return to the fundamentals of its mandate: ensuring price stability
• The ECB is expected to confirm the end of its assets purchase programme in the third quarter and to reiterate its willingness to raise rates thereafter. Only the uncertainty over the evolution of the invasion of the Russian forces in Ukraine is holding back more outspoken and rapid action
• We do not expect a timetable for a rate hike, but the ECB could indicate its willingness to do more if inflation were to be stronger and more persistent than expected, which would continue to fuel the upward correction in euro-zone rates

The European Central Bank (ECB) is under pressure. In March, it took a step towards normalising its accommodative policy by accelerating the pace of the reduction of its asset-purchase programme, but without opening the door to a rate hike in the third quarter. Since then, the conditions have changed:

• Inflation continues to rise and surprise on the upside. With an annual rate of 7.5% in March compared to 5.9% in February and 6.7% expected, inflation is now at an all-time high and sits at almost four times the ECB’s target.*
• Inflation expectations have started to drift upwards, with 5-year/5-year swap inflation (a measurement of “medium-term to medium-term” inflation) at 2.3%, compared with 1.9% at the beginning of the year.* The 5y/5y rate is also above the ECB’s medium-term objective of 2%. While there is no price-wage loop currently at work in the euro zone, with wage increases remaining contained, the risk of a shift in expectations and second-round effects has increased.
• The international context is one of tightening monetary policies. In particular, the US Federal Reserve (Fed) has announced that it is very determined to raise rates quickly and sharply, and that it is ready to rapidly reduce the size of its balance sheet.
• Finally, the uncertain economic and financial context – made more volatile by the invasion of Ukraine by Russian armed forces – is resulting in an additional inflation shock, particularly on energy and food prices.

In these conditions, it seems difficult for the ECB to justify its very accommodative monetary policy. At the next meeting, it should therefore announce – as the Fed has done loudly – a return to the fundamentals of its mandate, which is to ensure price stability. Whatever the profile of inflation in the coming months, and even if a deceleration is most likely (as stressed recently by several Board members), it is inconceivable for the central bank to remain passive in the face of current price levels. Especially since financial stability – which is often referred to as the ECB’s secondary mandate – does not seem to be at risk at this stage, given the levels of spreads and manufacturing indices (eg, the purchasing managers’ index, or PMI).

The minutes of the ECB Governing Council meeting of 10 March confirmed that this issue is increasingly present in the discussions. The divergence between its members has widened, but the balance of power is increasingly in favour of rapid tightening. Only the uncertainty over the conflict in Ukraine remains a brake on more forthright and rapid action.

We believe that the ECB should therefore confirm the end of the asset purchase programme (APP) for the third quarter, and perhaps even announce a specific end date. The ECB is also expected to reiterate its willingness to raise rates following the end of asset purchases. Markets are expecting two 25-basis-point hikes before the end of this year. The ECB is not expected to announce a timetable for these hikes, but it could indicate its willingness to do more if inflation is stronger and more persistent than expected, which would continue to fuel the upward correction in euro-zone rates.

*Source for all data: Bloomberg as at 8 April 2022.

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