Frederik Ducrozet, Strategist, and Nadia Gharbi, Senior Economist Pictet Wealth Management.

• The relentless rise in inflation has led most central banks to start normalising their policy stances. The ECB stands out as more dovish, with good reasons, but the patience of the central bank’s hawks is likely to wear thin as underlying inflation pressures continue to build over coming months.
  
• We have brought forward our forecast of ECB rate hikes, including two 25 basis point rises in March and June 2023, bringing the deposit rate back to zero. This would result in a less accommodative, but not a restrictive policy stance. We also expect the ECB to confirm that the TLTRO special interest rate will not be extended beyond June 2022, while the tiering multiplier should be increased.
  
• The ECB’s main challenge will be to engineer tighter financial conditions but not an unwarranted tightening. Ending quantitative easing by December 2022 may require the ECB to implement new contingency tools allowing for a resumption of net asset purchases in case of a sharp widening in peripheral spreads.

When facts change, what do you do ECB?

Six months ago, the ECB announced the results of its strategy review and committed to keeping an “especially forceful or persistent” monetary stance as the economy was stuck at the lower bound. Inflation had started to rise but was thought to be transitory. Since then, the Fed and other central banks have left the ‘transitory’ camp and are trying to get ahead of the inflation curve.

To be sure, there is no reason for the ECB to follow the Fed on a swift normalisation path of the monetary stance. The euro area medium-term inflation outlook still looks subdued, and the economic cycle lags the US’s in every dimension – from the fiscal response to real activity, inflation and, crucially, wage growth.

True, the impact of the Omicron wave on economic activity has been less severe and shorter than feared. ECB Chief economist Philip Lane highlighted in a recent interview that “there’s less concern about Omicron than we had in December”. Economic activity has lost momentum following the rebound in Q2/Q3 2021, mainly driven by weakness in the services sector, but business confidence surveys has stabilised in the manufacturing sector as supply-chain disruptions have started to ease. Geopolitical risks have risen with the Russia/Ukraine tensions, but some other risks have eased, including in Italy with the reappointment of Sergio Mattarella as President of the Republic. In all, the ECB is likely to maintain a broadly constructive view on the growth outlook.

Meanwhile, inflation has been higher and more persistent than expected, but this surge has been mainly driven by energy costs and supply-side constraints rather than by demand. Inflation surprised to the upside again in January, despite the negative base effect of the German VAT, although this was due to higher energy and transportation costs as well as a few services prices and statistical effects. The ECB will focus on upside risks in its communication, and upward revisions to staff projections are very likely again in March. But, the bar for above-target inflation to prove persistent, and for the ECB to effectively tighten policy, remains high.