ECB May As Well Just Quit Now

Convoluted. That’s a one-word description of the ECB’s October meeting, which found Christine Lagarde and friends grappling with a macro environment that’s every bit as torturously baffling as policymakers’ fraught efforts to navigate it.

As expected, Lagarde delivered another 75bps hike, doubling the policy rate in the process, while simultaneously dropping key hawkish language from the statement.

Previously, the ECB planned to raise rates for “several meetings.” As of the October statement, they merely intended to raise rates “further.”

In a largely asinine attempt to explain the discrepancy (which wasn’t lost on markets), Lagarde said that “It might well be ‘several meetings,'” which makes you wonder why they just didn’t keep the same language.

She said the ECB has “made progress” on the path to normalization. That’s certainly true if you’re benchmarking against the ECB’s starting point, which was negative 50bps. But neutral is (probably) around 2%, terminal pricing was in excess of 3% and inflation is 10% (figure below). So, I’m not sure “progress” is the best word. The tragic irony is that going any further could constitute a policy mistake.

“The ultimate destination that we want to reach is the rate that will deliver the 2% inflation target in the medium-term,” Lagarde went on to explain. “And that rate, by the way, is not necessarily the rate at which will consider normalization completed.”

That’s just a needlessly circuitous way of saying rates may need to drift into restrictive territory, but I’d reiterate that nobody even knows where “restrictive” is in the eurozone context. The statement and Lagarde’s allusions to recession, prompted a dovish knee-jerk reaction in market pricing for the terminal rate, which plunged by more than a full hike (so, more than 25bps) to around 2.65%. That, in turn, undercut the euro, which likewise dove. A plunging currency is conducive to imported inflation, something Europe knows all too well.

When taken in conjunction with the Bank of Canada’s step down, the RBA’s deescalation (which, by the way, already looks foolhardy in light of a hotter-than-expected inflation print down under) and “rumors” that Jerome Powell might telegraph a slower pace of hikes starting in December, it’s plain that central banks are in the midst of a mini-pivot.

Of course, if the ECB wants to be cautious, they’ll be forgiven. The bank never completely shook the ghost of an ill-timed hike in 2008, and it’s going to be a very rough winter across Europe. PMIs out earlier this week suggested activity is decelerating, and sentiment is awful. At the same time, I’ve repeatedly argued that the bank’s capacity to influence price growth is limited, and that inflation outcomes depend largely on the evolution of energy prices, the success of the bloc’s plans to contain them and, relatedly, the war in Ukraine.

Although the ECB’s hiking campaign (200bps in three months) has no precedent at the bank, it’s nevertheless too little, and too late. The bank is a side show in the inflation fight. These hikes are about credibility, which is not nothin’, as they say, but I fail to see any utility in additional moves beyond the 50bps increase that’s still priced in for December. As I put it a few days ago, a terminal rate of 3% would mean hiking 350bps out of negative territory in less than a year, and into the teeth of what could turn into a deep recession amid a raging ground war on NATO’s European doorstep. That’s a laughably perilous proposition.

The ECB also tweaked the TLTRO III rules in a bid to encourage prepayments, and made a remuneration change. There was some controversy around the TLTRO tinkering. Those are preexisting agreements, which means tweaking them (or “recalibrating” them, as the ECB put it), is tantamount to altering an official arrangement after the fact. Some program participants aren’t enamored with that, particularly given the implications of the new terms for what was a free lunch. It’s not so much the optics around the free lunch bit that are problematic, it’s the prospect of encouraging additional lending when inflation is out of control that policymakers want to address. There will be some irritable rumblings, but ultimately, banks may want to avoid publicly insisting on a pseudo-contractural right to earn a risk-free profit when so many European households are struggling just to keep the power on.

As for QT, the ECB will talk about it in December and establish “principles.” If it ever starts, it won’t be soon.

It’s exceedingly difficult for me to imagine Lagarde making much additional “progress” from here given harsh economic realities in Europe. Assume another 50bps in December and you’ll be at 2%. That’s probably about as “normal” as “normalization” is going to be. The euro’s Thursday drop, less aggressive terminal rate pricing and bull steeping all suggested markets believe the ECB’s hiking “cycle” is likely to be over less than a year after it began. If not (much) sooner.