Did the ECB ease too early?
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Tomasz Wieladek is chief European economist at T Rowe Price and a CEPR Research Fellow.
In most previous ECB cutting cycles, the signals to cut from the real economy and inflation rate were clear. That was not the case at the June meeting.
Recent inflation data has continued to come in hotter than the ECB expected. It could be even argued that — in the absence of the forward guidance ahead of the June meeting — the ECB may not have cut interest rates.
It is of course impossible to know if inflation will now slowly converge to a 2 per cent target or if it will remain persistently above target for a prolonged period of time. As ever, things will only become clear in hindsight.
The ECB is relying on its projection to cut rates. This was one of the major justifications at the press conference by Christine Lagarde. Underlying this forecast are two main assumptions: a strong rebound in labour productivity, and a rapid decline in pay per employee. Reality continues to challenge the former assumption. Labour productivity is still shrinking, albeit at a smaller pace. And surveys don’t suggest the rise in labour productivity embedded in the ECB forecasts is coming. The forecast of much lower pay per employee is based on the ECB wage tracker and Indeed wage trackers. But the former can be revised.
Importantly, German metalworkers’ union IG Metall recently announced a 7 per cent wage demand, versus 7–8 per cent in the previous year. Other German unions tend to follow IG Metall in their wage demands. Given the significant labour shortages in Germany at the moment and still historically low unemployment, there is a significant risk of another strong pay settlement. This means that Unions have more bargaining power than in the past. There’s a fight ahead, and it isn’t at all clear that future pay settlements will be in line with the ECB’s forecast assumptions — they could be a lot higher.
There is a historical precedent to the ECB both hiking and easing too early. Most market participants will be familiar with the premature 2011 hike, following the global financial crisis. But fewer will recall April 1999 — when the ECB cut the deposit rate by 25 bps, only to raise it again in November as an acceleration in the economy led to stronger inflation than expected.
Are we in for a repeat of 1999? I conducted an event study to look at the data around the first previous ECB cuts, relative to today. Real activity data looks like April 1999, but services price surveys from the purchasing managers’ index (a proxy for inflation data) continue to decline, unlike in April 1999. But the Employment PMI looks similar to April 1999. Clearly, the latest PMIs have declined as a result of a hit to confidence from French political risks. But such effects tend to be shortlived. Real wage growth and falling energy retail prices will support the continued economic rebound. Things look more like April 1999 than is comfortable.
Any inflation pressures, especially in the services sector, will be exacerbated by the 2024 Olympics in France, the Euro 2024 in Germany and a healthy dose of Taylor Swift concerts. Clearly, services price rises in response to these events should be treated as temporary. But it is hard to separate temporary from structural inflation effects in real time. The ECB may feel it needs to react.
On the supply chain side, container prices from Shanghai to Rotterdam have risen significantly. Yes, they are still far away from the levels seen in 2021, but the risk that goods prices start rising again is clearly present.
If the ECB has eased policy too early, when will we know? Should momentum in services inflation remain as strong as it has been in the last three months, it should take just three to four months to see if things are on a different path from the ECB’s projection.
What could the ECB do if services inflation ends up significantly more persistent than expected? The most likely outcome is a delay in the cutting cycle. Rather than cutting every quarter, the ECB may have to keep rates higher for longer. The ECB has pivoted from pure data dependence to greater reliance on the forecast. But persistently stronger than expected services inflation could challenge this approach and push the GC to put more emphasis on backward looking data again. This means that the bar for further cuts could rise significantly.
Overall, the risk that the ECB has cut prematurely isn’t small, taking into account the strong wage and services inflation pressure seen in the Euro Area. It could be a hot, sticky summer in Frankfurt.
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