ECB May 2023 Preview: hawkish Mojo
Summary • With the ‘Angst of the Month’ – the failure of SVB bank and Credit
Suisse – firmly in the rearview mirror, expect the ECB to rediscover its
hawkish mojo. Relatively speaking of course, because this is the Lagarde
ECB after all, not the Weidmann ECB that could have been (more on that
on the final page);
• Our call: despite a 50bps rate hike back firmly on the table, we expect
a compromise: a 25bps hike on Thursday May 4, but with hawkish
guidance that there is no stopping the rate hike train yet. The ECB will
tee up another quarter point hike for the June meeting. And Lagarde &
Co will lean towards more hikes over the summer. Core inflation and
wage growth are simply way too high, offsetting improvements in the
data elsewhere;
• Everything revolves around core inflation. Just two days before the
meeting we will get the preliminary inflation figures for April.
Furthermore, the ECB will pay close attention to the Bank Lending
Survey that is released the same day. Thus, our call can become obsolete
very quickly;
• This report is divided in two parts. In the first three pages we discuss
the economic backdrop that functions as the input to the Governing
Council’s decision. Readers who are less interested in the economic
raison d'etre of our call can simply skip to the final paragraph on page 4
and read two more pages on the nitty gritty of the meeting.
It is safe to say that the outcome of the May 4 ECB Governing Council meeting is a coin toss. A coin toss between a
25bps or a 50bps hike. For starters, ECB-speakers cannot seem to make up their mind about Thursday’s rate hike
increment. And as of yet, there have been no leaks to the press that pre-announce the outcome of the meeting.
Furthermore, the members of the Governing Council are putting particular emphasis on incoming economic data,
having seemingly done away with forward guidance and putting less emphasis on forecasts. To make matters even
more exciting, two days before the meeting, Eurostat will release preliminary inflation figures for April.
While Eurostat’s monthly inflation readings are without a doubt the pivotal indicator, the ECB is looking at a much
broader set of economic data inputs. In this note we discuss the dataset, or dashboard, that the ECB chief
economist Philip Lane uses when he makes his proposal for the Governing Council statement. We use the
dashboard – or at least our interpretation of the dashboard – as the key input for our call for Thursday’s meeting.
The table on the next page shows what we dub the so-called ‘Lane indicators’: a series of mostly economic data
points that will prove crucial in determining the size of the May hike.1 The indicators are our interpretation of
various data points Lane discussed in his speech from last March, which you can read here. We use a condensed
version of the Lane indicators. After all, Lane has plenty of staff – a battalion of economists, statisticians and
perhaps even astrologists2 – to track a broader variety of data and construct proprietary indicators, something we
are not able to match. For example, Lane and other ECB-speakers regularly refer to the central bank’s proprietary
wage tracker, which is based on micro data – think actual collective bargaining agreements – in the largest Euro
Area member states. Despite our best efforts, we cannot find the ECB wage tracker anywhere on its website. We
use monthly Dutch wage data instead, which is published with a very short lag of a few weeks after the end of the
month. We consider Dutch wage data to be representative for the largest member states for the simple fact that
there is no alternative available. In fact, in the five biggest member states, the Dutch statistical agency is the only
one of its kind that publishes timely high-frequency wage data.
In any case, the bottom line is that we condensed and streamlined Lane’s dashboard in our own set of indicators
that is both representative and timely in nature.
1 With the banking panic having receded, we can safely dismiss a pause.
2 Let’s no forget about AI. I am pretty sure the ECB will follow fashion and triumphantly announce something.
Note the colored cells, with red cells denoting stronger inflationary pressures, while green denotes the opposite. 3
Also be aware of net percentages, which only tells us something about the direction of an indicator, but not its
level. For example, in January a larger share of banks in the ECB’s survey expected a decline in corporate loan
demand. This, however, tells us nothing about the overall level of loan demand from corporates. The same applies
to selling price expectations. In each month we see that the relative number of firms expecting selling prices to
increase shrinks. That tells us nothing about how strong (or weak) firms expect the price increases to be.
Summarizing the Lane indicators, we see the following: a mixed bag.
Core inflation remains particularly strong, which is of great concern to the ECB. When we sift through recent
ECB-speak (spreadsheet with ECB-speak available on request), we see that even dovish leaning members judge
core inflation to be both way too high and sticky. We take particular note of comments made by the Belgian
central bank head Pierre Wunch (a bellwether for the mood on the Council) on the matter. On April 24, Wunsch
warned that high and sticky core inflation has resulted in so-called second round effects (anyone still old enough to
remember the Trichet years will know the code words the former ECB President used: “strong vigilance”, “second
round effects”, etc.). Or persistently high inflation resulting in stronger wage increases – with strong connotations
of a price-wage spiral. Long story short: until annualized monthly changes increases in core inflation start to fall
below 5 percent persistently, the ECB will have a strong tightening bias.
However, with survey data showing inflation expectations are easing, and with headline inflation down markedly,
even some of the most hawkish Governing Council members – the head of the Bundesbank in this case – are now
expecting core inflation to peak in the coming months. Bundesbank President Joachim Nagel said exactly that on April 17: core inflation will peak in the summer, but with the asterisk that it will remain far too high. In any case, while the ECB will take heart from easing inflation expectations, for the overwhelming majority on the Governing
Council, the proof of the pudding is in the eating. Core inflation has to fall persistently.
April 17: core inflation will peak in the summer, but with the asterisk that it will remain far too high. In any case,
while the ECB will take heart from easing inflation expectations, for the overwhelming majority on the Governing
Council, the proof of the pudding is in the eating. Core inflation has to fall persistently.
The ECB analysts’ survey (‘Survey of Monetary Analysts’, you have to be a banker to take part) shows that analysts
keep upping their core inflation estimates in each survey. How on earth we will get to 3.6 percent core inflation by
year-end beats us. So, expect the analyst guild to keep upping their forecasts in the upcoming surveys. And the
ECB will judge these recurring forecast changes as reflecting the persistent nature of high core inflation.
Lower expected loan demand, higher bank lending rates and modest declines in bank credit creation are the result
of past ECB tightening. Interestingly, according to Bundesbank estimates most of the pass-through from monetary
tightening on inflation is still to be felt, even though the pass-through to bank lending and interest rates is
advanced. While the ECB might take comfort from the contraction in bank credit creation, we are cautious.
Remember Irving Fisher’s equation of exchange? The money supply times velocity equals nominal GDP. While the
money supply is shrinking on both sides of the Atlantic as a result of depositors piling into money market funds
and the contraction in bank credit. However, in the US the monetary contraction has been offset by a recovery in
money velocity. And as readers of Milton Friedman’s A Monetary History of the United States will know and
understand, most US recessions are ‘caused’ by a decline in the velocity of money, not a contraction in the money
supply.
Economic growth, as measured by the PMI, has picked up in the first quarter, with further strengthening in the
early spring. Detailed data from the PMI suggests the rebound is the result of the services sector. So, domestic
demand. Manufacturing is contracting as global growth continues to cool. In any case, we have the ECB top brass
congratulating itself that the Eurozone economy is doing better than expected. We had Vice President Luis de
Guindos on the wires on Wednesday April 26 saying that the bloc will dodge a recession. That is: avoid two
consecutive quarters of negative quarterly GDP growth. That should make our central bank overlords more
hawkish, but apparently not this lot. We have a feeling that many on the Governing Council believe that they can
have their cake and eat it: no recession and inflation back at 2 percent. We, on the other hand, don’t believe in
such fairy tales.
Parsing the data, we see a picture of the Euro Area economy weathering the storm of tighter financial conditions,
the war in Ukraine and its consequences, and slower global growth because of resilient domestic demand.
Relatively strong domestic demand is also the reason why underlying inflation is high and engrained. ECB-speakers
– even middle of the road types and some dovish leaning members – are drawing little comfort from falling
inflation expectations because of punitively high core inflation.
We can now easily make the case for another 50bps hike at the May 2 meeting. For starters, core inflation is
uncomfortably north of 5 percent, while the deposit rate is just 3 percent. German and French real rates continue
to hover around zero, a level we judge to be too low if the ECB is serious about inflation. Dutch base wage
increases of approaching 6 percent are far too high, given tepid trend productivity growth that is 1.0 percent – on
a good day that is. And while ECB staff and bank analysts expect core inflation to ease over the course of the year,
the data do not confirm these goal-seeking forecasts.
Before the March Governing Council meeting, we called for a 50bps hike that month before a likely 25bps in
May and a 4.25 percent terminal rate. The banking panic never impressed us, hence we did not abandon our call.
After the March meeting, we even warned that 50bps would be on the table even though markets had priced
out even a 25bps hike. And on cue, this is exactly the state of play.
We continue to stand by terminal rate estimate, with the hawkish qualification that it is quite low when one takes
core inflation of more than 5 percent into account.
The rate hike increment next week literally is a coin toss though. Our headcount of ECB-speak shows the
following. Out of seventeen talking heads, nine specifically mention 25bps or 50bps; one proposes 50bps; five
mention no preference; and just two prefer no change or a 25bps increase. In the 25bps or 50bps camp, we find
middle of the road types (chief economist Lane), bellwethers (Wunsch) and hawks (Schnabel, Nagel). The dovish
contingent needs no mention as it consists of the usual suspects. Interestingly, another bellwether – Bank of
France President Francois Villeroy de Galhau – put his foot down by explicitly calling for 25bps. Bottom line: the
explicit nature of ECB-speakers’ comments on the rate hike increment suggests things are getting heated, and that
positions are hardening.
What will decide the rate hike increment next week are the following: April inflation data (to be released on
May 2); March monetary data (released at the end of this month); the Bank Lending Survey (also released on
May 2); and any events that might intrude. Since we have no way of forecasting this crucial data barrage, 25bps
or 50bps is the aforementioned coin toss. No prize for guessing how the data, and inflation data in particular, will
affect the outcome of the meeting.
Readers of our ECB Research will know that we do not like to hind behind probabilities, be it 50/50 or its
equivalent: 60/40. Thus, let this be the call. As part of the compromise, 25bps but with hawkish guidance.
Instead of the meek guidance that we got in March, expect stronger wording that there is no stopping the rate
hike train yet. Lagarde & Co will tee up a 25bps hike for the June meeting, plus the wording will be as such that
the door remains open for further hikes in the third quarter.
Regarding the other complexities of ECB policy, expect no announcements on the maturing TLTROs, Quantitative
Tightening or reform of short-term interest rates control. The ECB increasing the pace of Quantitative Tightening in
Q3 is a given though. In our liquidity estimates we have simply assumed to pace of Quantitative Tightening to
double to 30 billion euros a month, but we might need to take a deeper look into the (potential) complexities of
the balance sheet rundown.
As per our prior report on the ‘Italian Problem’ of low liquidity levels in Italy’s banking system, we expect the ECB
to herd banks with low reserves into regular refinancing, but with a more attractive interest rate (i.e. MRO rate
equal to the deposit rate). Corridor-narrowing interest rate hikes should happen in Q3, though we clearly
understand time is short for the ECB to tweak its framework. If there remains a spread between the MRO rate
and the deposit rate, the ECB could perhaps extend the maturity of the regular LTROs to six months from three
months. But that would be it. No more TLTROs. In the high inflation environment, with still extraordinary high
levels of bank reserves in most Euro Area member states, and with the stated aim of putting the brakes on bank
credit creation, there is no justification for the ECB subsidizing bank credit creation through cheap(er) funding
for banks.
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