A pragmatic ECB

Comments by Franck Dixmier, Global CIO Fixed Income at AllianzGI, ahead of the ECB meeting on 10 March, 2022?

• The Russian armed forces’ invasion of Ukraine has shaken things up for the European Central Bank, whose hawkish tone had surprised us at the last meeting
• In view of the inflation and growth risks, we believe that the ECB should announce that while maintaining the normalisation of its monetary policy, it will postpone it and modify the previously announced sequence of waiting for the end of asset purchases before carrying out a first rate increase
• The announcement of continued asset purchases and a first rate hike at the end of the year should be well received by the markets

The last European Central Bank meeting on 3 February left investors confused, notably because of the stark difference between the press release and the conference, during which Christine Lagarde adopted a hawkish tone in reaction to ever higher inflation. However, the ECB president had said on 10 March she would present more data to help clarify her timetable on asset purchase reductions, before taking decisions on key rates.

The expected clarification will not take place. The Russian armed forces’ invasion of Ukraine has completely changed the situation. The difficulty in predicting its evolution and duration, as well as the extension of sanctions, notably potentially to the purchase of Russian oil and gas, means there’s a high level of uncertainty about the economic consequences for the euro zone in terms of inflation and growth. However, the ECB is due to present its new economic forecasts.

Inflation surprised again in February, with 5.8% compared to the expected 5.6% and core inflation rising steadily to 2.7%[1]. The sharp rise in energy prices, but also in raw materials and wheat following the military aggression, should act as an additional transmission belt, while second-round effects (wage increases) can no longer be ruled out. Furthermore, the depreciation of the euro and the rise in oil and gas prices in dollars should reinforce the inflationary spiral. ECB Board member Isabel Schnabel recently announced that inflation would not slow down below 2% in the medium term, which is a condition for raising rates[2]. It is now clear that the peak expected in mid-2022 should be pushed back in time.

On the growth side, inflation should act as a tax on consumption, while the climate of uncertainty should depress investment and discourage dissaving. According to Philip Lane, the ECB's chief economist, European growth could be reduced by 0.3% to 0.4% in 2022[3]. This sounds very conservative.

Faced with the scenario of rising inflation and falling growth, with an extreme risk of entering a stagflation scenario, the ECB finds itself in a complex situation. At a press conference at the French Ministry of Economy on Friday 25 February, Christine Lagarde said she was ready to take any measure necessary to ensure price and financial stability in the area.

Indeed, risk aversion has led to a sharp movement in markets, as well as a widening of credit and periphery spreads, which amounts to a tightening of financial conditions. It is also facing a de-anchoring of inflation expectations in the face of the energy shock. The 5-year in 5 years is now at 2.24%, and the 5-year breakevens on the Bund at 2.97%, 100bp higher than in early February[4].

In this context, we do not expect any questioning of the will to normalise a monetary policy that remains ultra-accommodating. On the other hand, the pace of normalisation should be adapted and postponed in time to cope with an uncertain situation. We believe that the ECB should announce a departure from the previously announced sequence of waiting for the end of asset purchases before making a first rate increase, while maintaining a very flexible strategy. The central bank should, therefore, announce the continuation of securities purchases, without a timetable for completion, within the framework of the asset purchase programme to support the economies in the face of the recessionary shock, while announcing a first rate hike at the end of the year to reinforce pledges on its fight against inflation.

The central banks' put is still there, although one might have doubted it in the light of recent speeches. In a crisis, the ECB has always demonstrated its ability to support the economy and the markets. It should not depart from this approach.

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[1] Eurostat, March 2022: https://ec.europa.eu/eurostat/documents/2995521/14358044/2-02032022-AP-EN.pdf/617fee08-c46f-453a-a308-4fa3d33f4aae

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[2] Bank of England Agenda for Research conference, February 2022: https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220224~232cb567cd.en.html

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[3] Reuters interview, February 2022: https://www.reuters.com/business/exclusive-ecb-policymakers-told-ukraine-war-may-shave-03-04-off-gdp-2022-02-25/

[4] Bloomberg data, March 2022