ECB seen on hold but may acknowledge inflation risks

[February 03, 2022]  By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) - The European Central Bank is all but certain to keep policy unchanged on Thursday but may have to acknowledge that inflation could stay high for longer than it had projected, a signal that may be taken by some as a hint at a faster exit from stimulus.

Having extended support measures only in December, any policy change now would be premature. Yet inflation has consistently exceeded the ECB's forecasts, piling pressure on policymakers to fine-tune their increasingly questioned narrative that rapid price growth is merely temporary.

The bank argues that inflation will soon abate without its intervention and that long-term price pressures are actually too weak, meaning support is still needed to underpin inflation which undershot the ECB's 2% target for much of the last decade.

This view is now being challenged by investors and several policymakers, and January's 5.1% inflation print, the highest ever for the 19-country euro zone, only adds to pressure for ECB President Christine Lagarde to acknowledge mounting risks.

"The ECB's hopes for a rapid decline in the inflation rate are fading," Commerzbank economist Christoph Weil said. "The pressure on the central bank to exit its ultra-expansive monetary policy as early as 2022 is increasing."

But changing the inflation narrative is a tricky and potentially risky exercise.
 

Markets already doubt the ECB and are pricing in 30 basis points of rate hikes this year, despite its insistence that any move in 2022 is very unlikely.

If Lagarde admits that the ECB has underestimated price pressures, markets will bring forward rate-hike bets, tightening financing conditions and offsetting the very stimulus the ECB aims to provide.

CREDIBILITY

But with the bank's credibility already challenged by a string of forecasting errors and big upward revisions to projections, Lagarde also cannot ignore the inflation overshoots.

Instead, she may offer a token nod to inflation risks while emphasizing that price growth in Europe is fundamentally different to that in the United States given weak wage pressures and the relative lag in rebounding consumption.

The headquarters of the European Central Bank (ECB) are pictured in Frankfurt, Germany, July 8, 2020. REUTERS/Ralph Orlowski/File Photo/File Photo

The U.S. Federal Reserve is signalling a first rate hike in March although officials spoke cautiously on Monday about what might follow.

The Bank of England is meanwhile expected to raise rates again on Thursday and signal that it will start gradually reducing its vast holdings of government bonds, bought to stimulate Britain's economy.

With unemployment also falling to a record low, Lagarde may need to acknowledge that labour markets are tightening more rapidly than expected, even if so far that has not brought significant wage pressures.

But her main message is still likely to be that no rate move is coming this year, a framing that keeps the door open to an increase in borrowing costs early in 2023.

Long more cautious than markets, analysts too are now moving forward their rate hike predictions. While a Reuters poll last month saw a first ECB rate increase coming towards the fourth quarter of 2023, a growing number now see a hike as early as Q1.

"For now, we have pencilled in the first rate hike for early 2023, but an increase at the end of this year is increasingly likely," said Andrew Kenningham, chief Europe economist at Capital Economics.

Lagarde is unlikely to change her view that inflation will come back under target before year-end, however - an important provision that should keep rate hike expectations at bay.

The ECB will announce its policy decision at 1245 GMT and Lagarde holds a news conference at 1330 GMT.

The ECB is set to keep the deposit rate at a record-low minus 0.5% and stay on course to phase out its 1.85 trillion euro pandemic emergency bond buying scheme by the end of March.

(Editing by Catherine Evans)

[© 2022 Thomson Reuters. All rights reserved.]This material may not be published, broadcast, rewritten or redistributed.  Thompson Reuters is solely responsible for this content.