No need for ECB to raise rates to 4%

Hawks may be overestimating the inflation risks

Spring is in the air. The negative supply shocks that derailed the post-Covid-19 rebound of the euro area economy last spring and propelled inflation to a peak of 10.6% in October are going into reverse. The sharp correction in gas prices and the easing of supply bottlenecks will allow the economy to recover and inflation to fall faster than expected. This reduces the risk that inflation could become unduly sticky.

For the European Central Bank, that should be a reason to pause once it has raised its deposit rate to a roughly neutral level of 3% to 3.5%. However, the proverbial hawks on the ECB governing council seem inclined to steer their key rate to at least 4% instead. Fortunately, euro area fundamentals are now probably strong enough to limit the damage from such a policy mistake.

At first glance, the ECB hawks have a strong argument: inflation pressures have broadened out to ever more goods and services. Although headline inflation has declined from 10.6% year on year in October to a still exorbitant 8.5% in February, core inflation, excluding energy and food, has accelerated from 5% to a new record high of 5.6% during this period. However, a more detailed look reveals a more nuanced picture.

Monetary policy can rein in demand. But apart from some post-Covid-19 rise in spending for leisure, entertainment and tourism, there is little evidence that strong demand is driving inflation for non-energy goods and for services. Instead, the 2022 surge in energy prices is still working its way through the production chain. For example, my hairdresser raised her prices recently by 25% to cover her heating bill. She is unlikely to do so again.

Almost all observers expect the base effects from last year’s one-off spike in energy and food prices to lower headline inflation significantly from March onwards. What seems to be less understood is that the same will happen with a lag to the indirect impact of energy costs on other goods and services.

Until early 2022, the ECB had underestimated the structural uptrend in underlying inflation. The bank may now be succumbing to the opposite mistake. The ECB expects inflation to still average 3.4% in 2024 according to its December staff projections. We forecast a fall to 2.4% next year instead. The ECB is concerned on several counts: inflation expectations could become unanchored, the end of government subsidies could raise energy prices again in 2024 and trade unions may set off a wage-price spiral. In our view, the ECB is overstating these risks.

Start with energy prices. According to the ECB’s December staff projections, the end of temporary government interventions into energy markets will add 0.7 percentage points to headline inflation in 2024 and another 0.4 points in 2025. However, futures prices for gas have corrected sharply since the ECB’s December projections – from €130/MWh to €48/MWh for the 14-month Title Transfer Facility benchmark contract. The futures price for spring 2024 is now below the level that is consistent with the average price that euro area consumers paid for gas in February this year. Short of a renewed major spike in market prices for gas and electricity, energy prices for consumers and industry may even decline modestly instead of rising in 2024.

This leads to inflation expectations which often reflect recent changes in headline inflation. The ECB reported on 7 March that consumer inflation expectations are moderating. This process looks set to continue. In the European Commission’s consumer confidence survey, the reading for price trends expected over the next 12 months has already fallen below its 2017-19 average. The risk that elevated inflation expectations could drive a major persistent inflation overshoot looks somewhat remote.

Now turn to wages. Euro area wage dynamics usually follow major swings in inflation with a lag. After years of moderation, wages may well rise by 5% this year, as the ECB expects, before easing to gains of around 4% in 2024. As the ECB projects a mere 0.1% yoy advance in labour productivity for 2023, it forecasts an excessive surge in unit labour costs of 5%. However, the unwinding of the adverse supply shocks will help to raise output and lift productivity by at least 0.5% in 2023. If so, the rise in unit labour costs that companies will want to pass on to final consumers will be correspondingly smaller.

More importantly, the euro area is heading for a temporary hump in wages rather than a wage-price spiral. Germany’s mighty metal engineering and chemicals unions struck two-year wage deals when inflation peaked at 10% last autumn. Abstracting from complex details, wages will rise by 6% in the first year and 4% in the second. A similar pattern is likely to hold across the euro area, but on a slightly lower level: a temporary bounce in wage inflation in 2023 after years of wage restraint during the pandemic, followed by a deceleration to just below 4% in 2024. Wage deals for next year will be concluded against a backdrop of much lower rates of inflation.

As the negative supply shocks unwind, price pressures look set to ease significantly over the next 12 months without the ECB having to move rates well into restrictive territory.

Charting the course for rates is not the only challenge for the ECB. The bank also has to mind its credibility on two other counts.

First, its approach to guidance remains a baffling mystery. Shortly after the ECB formally ditched its forward guidance, the bank de facto pre-announced its next move(s) even more clearly than before, for instance by pointing to 50 basis point rate hikes for February and March 2023 at its December 2022 meeting. Whereas each of these moves made sense, likely reflecting hard-won compromises between hawks and doves, the way the ECB communicated its intentions did not.

Second, the ECB and its member central banks now have to dip into their loss provisions to cover balance sheet shortfalls stemming largely from the rise in interest rates and the corresponding drop in prices for bonds. Fortunately, the public seems to understand that this is par for the course for the central bank under the circumstances. Bundesbank President Joachim Nagel has explained the situation well to the German audience public. As a result, the visible fall in inflation is likely to shape public perceptions of the ECB more than the temporary dearth in central bank profits.

Holger Schmieding is Chief Economist at Berenberg.

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