Policymakers Get A Pep Talk

By Bas van Geffen, CFA, Senior Macro Strategist at Rabobank

Yesterday evening, President Lagarde opened the ECB’s annual policymaking conference. Unsurprisingly, the this year’s theme revolves around structural changes in the economy, and (model) uncertainty about the outlook for growth and inflation. Many of the discussions will be quite academic of nature. But Lagarde also offered a glimpse of the path forward. She noted that the ECB needs more time to assess inflation uncertainties, and that the strong labour market allows the central bank to gather more data before making a decision. That’s July definitely off the table then. However, policymakers still appear relatively confident that they can resume the cutting cycle in September – data permitting, of course.

This morning, the ECB’s policymakers will probably be egged on further. The ECB Forum on Central Banking starts with a discussion on the drivers of post-pandemic inflation. The authors of the paper argue “that there are reasons to be optimistic about inflation, both in the immediate and the more distant future.” Their model predicts an “easy last kilometre” back to target in the coming quarters.

That’s definitely what policymakers want to hear, even though several of their colleagues are warning against cutting rates to hastily from here on. Interestingly, the authors also conclude that the recent episode of high inflation was driven more by a unexpectedly strong demand, rather than just an (energy) supply shock. And consumption is expected to pick up again in the coming quarters; it’s unclear whether that is embedded in their projections, or whether such a development could drown out their cheer of an easy last kilometre.

And, while the ECB’s rate setters get a peptalk in Sintra, the EUR OIS market has further priced out the odds of rate cuts in the second half of the year.  Part of that was probably a side-effect of the relief rally after investors’ worst-case scenarios for the French elections did not play out. That said, incoming inflation data were not very constructive either.

At first glance, the German inflation rate may have given the Governing Council a bit of a confidence boost, ahead of today’s estimate for the Eurozone aggregate. The HICP inflation rate cooled from 2.8% to 2.5% y/y in June. However, scratching just a bit below the surface, the picture becomes mixed at best.

Data for the individual German states indicates that prices for goods, and in particular furnishing and household equipment, slowed whereas prices at hotels, and restaurants appear to have re-accelerated. Indeed, the breakdown of the CPI inflation showed that services inflation remained stable at 3.9% y/y – indicating that the rebound in May was not a one-off. The ongoing price pressures in labour-intensive areas of the economy is especially concerning if one takes into account that IG Metall, Germany’s largest union, is currently demanding a 7% pay increase.

This domestically driven inflation should be the key concern. A large part of the disinflation to date has been the result of lower price pressures in various goods, as supply chains and energy shocks fade. However, as we’ve warned on various earlier occasions, goods inflation alone cannot durably return inflation to target. A case in point is this morning’s flash estimate for Dutch inflation. Headline inflation accelerated unexpectedly to 3.4% y/y after 2.3% in May. That upside surprise was brought about by goods disinflation losing steam, while services inflation remains far too high at 4.6% (an increase from 4.5%).

On the sidelines of the ECB conference, Wunsch told Bloomberg that he would need convincing to support more than two cuts this year. “The first two cuts are relatively easy,” but to support further cuts, “we would need to have strong indications that [inflation is] moving below 2.5% to 2%.”

Such concerns about the last kilometer are not just a European thing. Persistent US inflation has forced the Fed to delay its first rate cut. And Australian policymakers have been on high alert ever since incoming data suggested that disinflation may not only have run its course, but that it may establish a new uptrend. It was a reason for our RBA-watcher to put additional rate hikes into his forecast. That view that is now increasingly finding support elsewhere in the market. The minutes of the previous RBA meeting note that policymakers judged the case for holding rates stronger than the case for a rate hike. However, they are certainly keeping the door open. Officials decided that updated economic projections will allow them to make a more careful assessment in August.

And that’s all based on inflation data and an inflation outlook based on the status quo. Policymakers traditionally do not include (expected) changes in, e.g., fiscal policy. Our US strategist has flagged the likely inflationary impulse should Trump be re-elected into office. Such a scenario is being seen as increasingly plausible. Trump continues to poll well, and yesterday the Supreme Court ruled that the former-President may enjoy some immunity from criminal charges over his attempt to challenge the 2020 election results. The ruling is bound to delay any trial to after the elections. This clears another hurdle to a Trump victory in November, following President Biden’s dismal performance in their first head-to-head last week.