Can the ECB pivot?
A change of language does not represent a change of strategy.
Some are interpreting the ECB’s policy statement last week as signalling a dovish pivot. But the ECB can only relax once core inflation has clearly peaked;
Looking at service inflation from a cross-country perspective, there is still a long way to go for policy this cycle.
We have moved a long way in rates this year already. This is hardly surprising given the acceleration in headline and, more important, core inflation throughout the year consistent with our previous analysis (see link)
Recently, though inflation has not yet peaked, the market appears to be sniffing out possible a pivot (which we define as a shift to more dovish rhetoric), with the Bank of Canada and Reserve Bank of Australia already embarking on smaller hikes and the ECB this past week perhaps suggesting hikes will slow from here.
Indeed, at the policy meeting last week, the ECB’s policy statement included a subtle change of language. The policy statement noted that their second 75bps rate hike in recent months hike means they have now “made substantial progress in withdrawing monetary policy accommodation… [and they] will base the future policy rate path on the evolving outlook for inflation and the economy, following its meeting-by-meeting approach.”
The latter language has been tweaked to reference the “economy” as opposed to just inflation, pointing to recession concern.
How likely is it that the policy decision represents a meaningful dovish pivot?
Well, we would first note, with strong sense of irony, that the Governing Council has trouble with time consistency in decision-making.
A version of this was on display last week when the terms of the Targeted Long-Term Repo operations—which turned out to be very generous to the banks—were changed (“recalibrated”) by the ECB. This complicates interactions between banks and the ECB in the future given the latter can change the terms of lending retrospectively.
But back to the issue of rate setting.
The Governing Council and President Lagarde have demonstrated on at least three occasions in recent months an inability to stick to their policy plans.
Initially, earlier this year—in keeping with their Strategy Review—the plan was to delay any hikes until well after net asset purchases were brought to an end. But this was abandoned at the first opportunity.
And at the time they abandoned this initial forward-guidance in June, the Governing Council also signalled the intention to raise rates by 25bps at the next meeting in July—only to hike by 50bps when the time came.
Then only in September, President Lagarde suggested “it will take several meetings” to get rates to a level consistent with their price stability mandate, meaning “probably more than two [meetings], including this one, but it's probably also going to be less than five.” Yet last week, when pressed about the language on future rate increases, Lagarde was more circumspect: “We know the path, we know the journey, we know the destination—which is not as clear as a figure that you would like to pin down because we cannot do that. We simply cannot do that.”
A sensible approach to any policy guidance right now is to not believe anything that President Lagarde says. She doesn’t know. And their meeting-by-meeting approach is acknowledgement that they have no policy strategy except to argue it out at every meeting depending on the evolution of inflation data.
And since they don’t yet know what inflation will be doing in 3 months, and therefore how panicked they will be at that time, it is best instead to ignore their signalling and think about the inflation dynamic, as we do below.