Morgan Stanley: So What Does The ECB Do Next?

By Seth Carpenter, Chief US Economist at Morgan Stanley

It’s tough all over. Central banks face difficult decisions as inflation keeps surprising to the upside. But as Yogi Berra’s advice suggests, they may not know where the road is taking them. The Federal Reserve hiked 75bp, 25bp more than was priced in just a week earlier. So much for forward guidance as a policy tool. At the June ECB policy meeting, President Lagarde also weighed in. She was clear that following a 25bp rate hike in July, the rate hike in September would be larger – presumably 50bp if the outlook for medium-term inflation was still above target. Put differently, if the ECB does not lower the 2024 forecast for inflation, we should expect 50bp.

A lower inflation forecast faces long odds as commodities prices matter a lot for the euro area inflation outlook. Euro area headline inflation is 8.1%Y, with core at 3.8%Y. Compared to the US, where headline is almost the same at 8.3%Y but core is 5.9%Y, European inflation is much more noncore than core. Given the likely path for energy and food prices, a lower forecast for 2024 headline inflation does not seem to be in the cards. For core inflation, the ECB views economic growth a year earlier as the key driver. It is very hard to see what data we will get by September that will affect 2023 growth expectations to push the 2024 core forecast below 2.3%Y and back to target.

So, the ECB has joined the ranks of central banks that are hiking more and more with the common goal of slowing inflation. The ECB’s aggressive reaction to headline inflation harkens back to the difficult arithmetic for the Fed that I discussed here in January.

The choice is stark:

i) either cause a recession and bring down inflation in the near term or

ii) engineer a substantial slowdown, but one that is shy of a recession, and accept elevated inflation for years.

Judging from the latest projections where core inflation stays above target for the entire forecast period, the ECB has chosen the latter route. Despite the lags of policy, if the ECB chose to engineer a recession now, the effects would almost surely show through before 2024.

One way to understand the ECB’s choice is its history with inflation undershooting the target. Decisively breaking that pattern might be attractive. This more cautious approach might also reflect the overweight of noncore items in euro area inflation – noncore prices are mostly exogenous to euro area activity. The recession required to drive down noncore prices would have to be severe. And while euro area unemployment is at its lowest level since the single currency’s inception, wage inflation has not surged (as it did in the US), so the economy is not obviously red hot. Finally, reports are swirling of a new tool to ward off fragmentation in European markets. A hard landing would very likely precipitate that outcome.

So what happens next?

Clearly, the Governing Council is set on a hiking cycle. The path for inflation depends on commodity prices and economic growth in the euro area.

We are more pessimistic about euro area growth, starting with the second half of this year, but with the lags in data reporting and the ECB’s focus on headline inflation, clear signs of slowing in the economy may not be evident in time to stay its hand. Although the ECB’s forecasts imply that it is choosing the more benign path, if our forecast is right, the risk of the ECB hiking into a recession – albeit inadvertently – is clearly rising.