‘Owl’ Lagarde Shows Talons As ECB Language Turns Aggressive

The ECB might’ve just become the most hawkish developed market central bank, an unfamiliar role for the institution in the post-debt crisis era.

Of course, if that interpretation of the December policy statement (and Christine Lagarde’s subsequent remarks) is accurate, it’ll only be because the ECB started from behind and is now playing catch up. Unfortunately for Lagarde, it’s the furthest thing from clear that monetary policy is the deciding factor when it comes to inflation outcomes in the eurozone.

The bank hiked rates by 50bps at this year’s final policy meeting. That was in line with expectations and brought the total tightening since July to 250bps (figure below), a Herculean feat considering the source.

The 12-month pace of inflation did moderate last month, but the disconnect with the policy rate still suggests the link between the two is tenuous at best. “There is very little the ECB can do to bring down actual inflation, but it can contribute to re-anchoring inflation expectations,” ING’s Carsten Brzeski said.

The statement language was aggressive. Or at least it seemed so to me. “The Governing Council judges that interest rates will still have to rise significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely return of inflation to the 2% medium-term target,” the bank said, citing the new staff forecasts.

Fresh projections found Eurosystem staff revising their inflation projections sharply higher for 2023 to 6.3% from 5.5% (figure below). That’d be an improvement from 2022, but that’s a pretty low (or, more aptly, a pretty high) bar.

Inflation is seen averaging 3.4% in 2024 — so, well above target for the foreseeable future. Core inflation is projected to average 4.2% next year, before falling to 2.8% in 2024. The growth forecast for 2023 was chopped down to 0.5% from 0.9%. Somehow, that still seems optimistic to me.

While editorializing around the new projections, the ECB was blunt. “The Governing Council decided to raise interest rates today, and expects to raise them significantly further, because inflation remains far too high and is projected to stay above the target for too long,” the statement said, reiterating the message from the opening paragraph.

The GC did raise the specter of a recession. “The euro area economy may contract in the current quarter and the next quarter, owing to the energy crisis, high uncertainty, weakening global economic activity and tighter financing conditions,” policymakers conceded, but said that if you go by the staff projections (And why wouldn’t you, right?) any recession “would be relatively short-lived and shallow.”

QT will commence in March. Initially, it’ll be passive (and partial) runoff at a €15 billion per month pace during Q2 2023. After that, the ECB will assess the situation and go from there, where that means the pace could be adjusted. Proceeds from maturing bonds purchased under PEPP (the pandemic emergency QE program) will be reinvested in perpetuity. As a reminder: The ECB probably intends to flexibly allocate principal payments from maturing PEPP securities to control any undue widening in periphery spreads associated with market volatility. The bank also announced an anti-fragmentation tool in conjunction with the first hike in July. “The future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance,” the statement said.

If you’re wondering whether that means the ECB will be engaging in passive QT through the APP portfolio (i.e., the bonds accumulated under “regular” QE) while still reinvesting the proceeds from the pandemic QE program in full, the answer is yes. That’s… well, it is what it is, for lack of a better way to describe the situation without lapsing into tired jokes.

Ultimately, this was a very hawkish hike. I suppose you could argue (as some did) that they could’ve opted for a third straight 75bps move with a more balanced assessment of the likely rates trajectory going forward. But the language employed on Thursday suggested the GC thought that’d be disingenuous to the extent it might create the impression the bank was inclined to “go big one more time and pause,” if you will. That clearly isn’t their intention.

Lagarde came out guns blazing. “Anybody who thinks that this is a pivot for the ECB is wrong,” she said, of the step down to 50bps increments. “We should expect to raise interest rates at a 50bps pace for a period of time. We have more ground to cover, we have longer to go and we are in for a long game.” She mentioned the Fed: “If you were to compare with the Fed, we have more ground to cover, we have longer to go.”

“If the ECB had to draw its own dot plot chart today, it would probably show the deposit rate at 3.5% by the end of 2023,” ING’s Brzeski went on to say. That’d tip another 150bps of hikes from today.

Suffice to say Lagarde who, upon taking the reins from Mario Draghi, famously described herself as “neither dove nor hawk” but rather an “owl,” has sharp talons after all.