ECB Meeting Preview: 3 things to watch

In less than a year since starting her job last November, President Lagarde has gone from normalising monetary policy and preparing a strategic review to facing up to the worst economic recession in living memory. We have seen unprecedented stimulus unleashed by the ECB, with the expansion and extension of the pandemic QE bond-buying program (PEPP) in June causing financial conditions to tighten, mainly owing to a stronger EUR in trade-weighted terms. With a new set of ECB staff forecasts and the Fed’s recent policy shift announcement, we think there are three main issues to concentrate on:

1. Euro strength – communication matters

The recent 5% appreciation of the effective euro since the start of the year should figure prominently in the Governing Council’s deliberations at this meeting. EUR/USD, referred to explicitly by Chief Economist Lane in his now well-known (supposed) jawboning last week is close to 10% stronger than was assumed in the June forecast round, where the assumption taken from the FX market was at 1.08 for the pair.

Will President Lagarde echo her colleague’s concerns? Notably, other ECB members have indicated that they are less worried about the exchange rate, seeing it more as a boost to global trade from a weaker dollar which would offset the drag on euro area exports from the stronger euro. Recent analysis suggests the appreciation so far might lower growth and inflation by about one quarter percentage point in each of the next two years, but such growth headwinds are a drop in the ocean compared with the 7% rebound anticipated for next year. Also of relevance is recent ECB research that has shown that the pass-through of exchange rate movements has fallen in recent times due to the low inflation environment.

Messaging will be key here as Lagarde will have to weigh acknowledging any concerns of the currency appreciation or else the market will take this as a green light to bid up the euro once more.

2. Low inflation – new staff projections

The upcoming meeting takes place against the backdrop of headline CPI running in negative territory (-0.2% y/y) for the first time since 2016, a 12% contraction in Q2 GDP and PMI readings showing signs of pulling back. Set against this is the rise in oil prices, labour market impact that has so far been limited and the fact that at 0.9% for 2022, the forecast for core inflation is already exceptionally downbeat.

The minutes for the June meeting showed that the Governing Council would be in a better position at this upcoming meeting to provide more clarity. But given the recent volatility in the data, the ECB may choose to look through the considerable shot-term variations and err on the side of caution regarding its new growth forecasts, while also emphasising the extraordinary stimulus already delivered and that some policies work with a lag.

On the inflation front, seasonal factors and domestic government initiatives like the German VAT reduction caused the negative print in inflation. Of more concern is that services prices are weak and have cooled noticeably since May. Along with euro appreciation, this has caused financial conditions to tighten since the last meeting, although a higher oil price forward curve and the June policy package will pull in the other direction, supporting inflation further out. In any event, any downward revisions will increase the likelihood of more monetary stimulus.

3. Strategy Review – AIT for the ECB?

Although the bank’s review is many months away from completion, there may be some interest in the Governing Council’s views on its approach to hitting its price stability mandate, given the Fed’s recent regime change to average inflation targeting. This has helped boost market-implied inflation expectation in the US, while the improvement seen in the Euro area from the March lows has stalled.

Expect that interest to be addressed with a very straight bat as Lagarde will not want to predict or obstruct the current discussions and conclusions of the ECB’s own review. Many analysts believe that the bank will move to a more symmetric target in time, calculated to be as flexible as possible.

There is roughly 10bp of ECB cuts priced over the next 12 months, so there are two-way risks as to which direction EUR could move in the short term. Market expectations of more easing or at least a dovish tone have increased lately so it seems Lagarde will not want to repeat past communication errors by sounding too optimistic.