About the ECB’s Apparent About Face

Whilst the European Central Bank (ECB) didn’t announce policy changes at last Thursday’s meeting, ECB President Christine Lagarde’s accompanying talk seemed to reverse course from her prior statements about inflation (economy-wide price increases). Before Thursday, Lagarde argued fast-rising prices were temporary and passing.^[i] Now she says inflation is “tilted to the upside” and could stick around for “longer than expected.”^[ii] This rhetorical shift sparked speculation the ECB will soon start raising its benchmark interest rate, when it signalled previously it would stand pat this year.^[iii] Yet—oddly, in our view—the data that likely helped motivate the switch also argue against it. We think this highlights, once again, that the ECB’s guidance isn’t actually that reliable. We also think it illustrates the folly of trying to predict what monetary policy institutions will do, no matter how data dependent they claim to be.

We think unexpectedly higher inflation likely contributed to the ECB’s changing its tune. Headline eurozone inflation hit 5.1% y/y in January—up from December’s 5.0%, above consensus expectations for a retreat and a record high.^[iv] This comes against the backdrop of persistently high inflation rates globally and monetary policy institutions’ increasingly taking action—and mounting pressure from some eurozone officials to follow suit.^[v] But in our view, there is a big, big caveat to that high headline figure: Energy prices, which accelerated to 28.6% y/y, remain the big driver.^[vi] Core inflation, which excludes food, energy, alcohol and tobacco, slowed to 2.3% y/y, moderating from December’s 2.6%.^[vii]

Now, the ECB targets headline inflation, not core.^[viii] But in our many years of observing them, we have seen monetary policy institutions fairly regularly look through rising prices when the drivers are volatile and narrow. Actually, the ECB appears to us to have been doing that since last July, when headline inflation breached the bank’s 2.0% target.^[ix] In our view, it isn’t clear why this latest data dump prompted the shift. The ECB could easily change its mind again, whether or not the data shift as well. Monday, Lagarde was back to downplaying inflation, saying: “There are no signals that inflation will be persistently and significantly above our target over the medium term, which would require measurable tightening.”^[x] What to make of the latest ECB-speak? We can’t tell—nor do we think anyone else can.

Curiously, whilst acknowledging fast-rising energy prices’ economic impact, the ECB didn’t mention the divergence between core and headline inflation rates when expressing “unanimous concern” about rising prices.^[xi] We think why is harder to know than what, but this appears like a case of a monetary policy institution trying to optimise politically. To us, this resembles what financial commentators we follow called the Powell Pivot back in November, when US Federal Reserve head Jerome Powell dropped the word “transitory” from his inflation vocabulary—for clarity’s sake, not necessarily because he thinks high inflation will be lasting.^[xii] More recently, consider the flak Bank of England boss Andrew Bailey drew last week, suggesting workers shouldn’t ask for pay raises in order to restrain inflation.^[xiii] In our view, explaining away what is hitting people in the pocketbook isn’t a good look with the public or the press. We think monetary policy institutions have long had a tough political line to walk. Most observers we follow thought Lagarde’s diplomatic credentials were why she got the ECB’s presidency despite lacking monetary policy experience.

Politics aside, we see a few implications here for investors. We find this episode shows yet again why monetary policy isn’t predictable and monetary policy institutions’ forward guidance isn’t ironclad. Over our long time monitoring them, their forecasts—and actions—have often shifted with public opinion. It looks to us like the data they supposedly depend on don’t act as guidance so much as after-the-fact rationalisations when they suit policymakers’ chosen narrative. They aren’t compasses, but weathervanes—nothing to go by, in our experience. We think investors are better off just waiting to see what monetary policy institutions do, as our research finds markets have no preset reaction to monetary policy anyway. In our view, trying to navigate these decisions ahead of time is futile and could very well be counterproductive.

Besides, our research shows rate hikes have no power over current price drivers. They won’t increase energy supply, pacify Russian President Vladimir Putin or address supply chain wrinkles, as Lagarde recognises.^[xiv] That said, if the ECB does move away from its present negative interest rate policy, which we think distorts banks’ lending incentives, so much the better, in our view. We think less negative short rates may even be somewhat more accommodative, as they would enable banks to stop charging for deposits, which we think is inherently contractionary for the economy. We find that is overwhelmingly what matters to the economy—the overall flow of money and credit—not noncommittal and subtle (or indecipherable) hints from monetary policymakers or incremental interest rate moves.