Consumer inflation respite enough for ECB to breathe

Whisper it, but inflation may have peaked in the eurozone. Consumer prices rose to 10% a year in November, down from 10.6% the previous month, but just as importantly the monthly number was negative at -0.1%.

Cementing the good news was the core measure excluding energy and food prices coming in at an unchanged 5%. This opens the door for the European Central Bank (ECB) to raise its official deposit rate by only half a percentage point to 2% on December 15, rather than subjugating the struggling euro economy to a third successive 75 basis-point hike.

Still, there will be plenty of unhappy interest-rate hawks on the ECB’s governing council flapping for a while yet, eschewing one month’s data as inadequate evidence that inflation has been tamed. Volatile headline numbers aside, the determinant of next year’s ECB actions lies in how much core inflation recedes, and how quickly.

Though the ECB was slower off the mark than other central banks, it is worth reflecting that official rates will have leapt from minus 50 basis points in July to likely at least 2% by the end of this year. That is quite some tightening in just six months, especially when combined with ending bond purchases under quantitative easing.

It is the price of consistently underestimating inflation. Before Wednesday’s release, the annual gains in consumer prices had exceeded market expectations for 16 months running.

The ECB had expected CPI to peak a year ago, so confidence in its own forecasting ability has been undermined. Forward guidance about where interest rates are headed has been ditched in favour of meeting-bymeeting data dependency.

This has led to a careful rethinking by the executive board on how to present its inflation approach to maintain the governing council’s appearance of unity.

“We are still in an unfortunate phase where monetary policy reacts to actual inflation, rather than inflation reacting to monetary policy,” as UniCredit chief economist Erik Nielsen put it earlier this week.

ECB president Christine Lagarde was careful on Monday to outline that there is too much uncertainty to call a peak for inflation despite widespread expectations that November’s number would be lower than October’s. Once bitten, twice shy, perhaps; but this now looks more like an effort to placate the hawks.

It has been quite the journey for Lagarde, starting in the summer with an interview with Madame Figaro in which she expressed the view that “we can no longer rely exclusively on the projections provided by our models — they have repeatedly had to be revised upwards over these past two years.”

In an October 28 interview with Irish state broadcaster RTE, Lagarde said “inflation had come out of nowhere”. She took a tougher approach in a Bloomberg News interview in early November, when she said that recession alone will not be “sufficient to tame inflation”.

ECB chief economist Philip Lane’s monster of a blog post on Friday — a mere 17,000 words — argued that the “conditional nature of inflation projections should always be fully appreciated”. A furry mammal caught in the headlights is my impression of the ECB’s current monetary policy stance. The hawks, who are led by German Bundesbank president Joachim Nagel, have not given an inch.

Dutch governing council member Klaas Knot on Monday made it clear that a “protracted period” of monetary tightening was needed. He said that any talk of over-tightening at this point is “a bit of a joke”.

That overstates the hawks’ case, seeing as much of the euro area is either already in a recession, or is shortly about to be. But the rhetoric battle is hotting up as to whether the ECB can ease its outsize 75 basis-point interest-rate jumps. But Lagarde will have to be on top of her game, at the press conference after the December 15 meeting, to persuade markets that the governing council remains united.

Also up for debate is how early in 2023 the ECB decides to start shrinking its €5.2-trillion QE bond pile by halting reinvestment of maturing debt; scaling back its balance sheet will reduce the availability of credit in the eurozone.

At the previous ECB meeting it decided to retrospectively alter the terms of its overgenerous targeted longer-term refinancing operations. This removes a profitable source of funding for commercial banks, and could lead to as much as €1-trillion of borrowing from the central bank being returned by the end of this year. Liquidity is being sapped from several angles at once.

Next month’s interest rate decision will not be easy, with inflation still running at five times the 2% target. The hawks will demand sustained evidence before backing off on the pace of monetary tightening. That almost certainly means recession as the price to be paid for exuberant pandemic stimulus.

A 50 basis-point increase strikes a fair balance between ensuring inflation does not become too embedded and not worsening the coming recession. With inflation showing promising signs of having peaked in the euro area, the ECB hawks need to be put back in their coop.

MONETARY POLICY REACTS TO ACTUAL INFLATION, RATHER THAN INFLATION REACTING TO MONETARY POLICY