Looking ahead to next week’s meeting, we discuss in our ECB preview that the Bank should resist the temptation to push back on very aggressive market expectations of upcoming rate cuts. Well, it seems ECB officials didn’t read our preview. Indeed, in recent days there has been an explosion of comments from national central bank governors about the possibility and timing of rate cuts. In fact, there were so many different comments that it made ECB watchers dizzy, wondering why the Bank had not extended the silence period or at least called an official Governing Council meeting in Davos. In the end, it was ECB President Christine Lagarde who had to intervene, hinting at a first rate cut in June. Interestingly, it wasn’t until November that Lagarde was quoted as saying that the ECB would not start cutting rates for “the next two quarters.” Once again, evidence is provided that central bankers should refrain from giving overly explicit future guidance.
In any case, even if real growth continues to be weaker than the ECB expected each quarter, as long as the eurozone remains in de facto stagnation mode and does not fall into a more severe recession, and as long as the ECB ECB continues to predict a return to potential growth rates a quarter or two later, there is no reason for the ECB to react to slower growth with imminent rate cuts. Furthermore, the task of bringing inflation back to target is not yet finished. In the coming months, the evolution of inflation will be determined by two opposing trends: further disinflation and potentially even deflation as a result of weaker demand, but also new inflationary pressures due to less favorable base effects, new inflationary pressures as a result of tensions in the Suez Canal, as well as government interventions in some countries, especially in Germany.
In this context of more upside than downside risks to inflation, any rate cut at the current stage makes no sense, at least not in the eyes of the ECB. In fact, new inflationary risks raise Arthur Burns’ argument again. No central banker wants to be another Arthur Burns, the chairman of the Federal Reserve in the 1970s, who is often said to have cut interest rates prematurely, setting the stage for a second leg of inflation. Or, to put it another way, central bankers didn’t see inflation picking up; they now want to be completely sure of falling inflation and will therefore by definition stay well behind the curve.
In the past, central bankers invested a lot of (communication) effort into being readable and predictable. However, in the current climate, the question is whether the ECB should really care about market expectations. The irony of market pricing right now is that it makes the need for real policy rate cuts less urgent. Financing conditions have eased since early December, doing the job that real rate cuts should do: supporting growth but also raising inflation risks. Consequently, the more aggressive the market prices future rate cuts, the less necessary and likely those cuts will be.
In recent days, ECB officials have been unable to resist the temptation to push back market prices, at the risk of being overtaken by real events and data. With Lagarde’s comments yesterday, the course is set for next week’s meeting. The main challenge now will be not to change communication and orientation again.