Comment by Frederik Ducrozet, Head of Macroeconomic Research and Nadia Gharbi, Senior Economist, at Pictet Wealth Management on the US macroeconomic outlook.
ECB preview: banking on policy transmission
A backward-looking ECB could still deliver a 50bp rate hike on Thursday, focusing on sticky core inflation, strong nominal wage growth, and little evidence of financial spillovers from last month’s bank turmoil.
However, a forward-looking ECB should move from cautiously from here, in our view, stepping down to 25bp rate hikes in full data-dependance mode, following three 50bp increases in policy rates so far this year.
Importantly, today’s credit and inflation data look consistent with the view that the ECB’s tighter monetary stance is being transmitted to the real economy, reducing the risks to the inflation outlook.
Even more importantly, a majority of heavyweight ECB officials have shifted to a more pragmatic stance, insisting on the need to proceed more cautiously from here as policy rates have become more restrictive and the lagged effect of monetary tightening has yet to be seen.
The ECB’s Bank Lending Survey conducted after the March events in the US and Swiss banking sectors was consistent with tighter credit standards and a “persistent weakening” of loan dynamics.
In fact, the net tightening in credit standards over the last two quarters was the largest since the sovereign debt crisis against the backdrop of higher interest rates and weaker economic prospects. Demand for loans decreased strongly, especially for loans to households for house purchases (more than during the Great Financial Crisis!) but also for corporates.
Moreover, banks stressed that the ongoing reduction in the ECB’s balance sheet as well as TLTRO repayments contributed to weakening lending dynamics, including the substantial TLTRO III amount maturing in June 2023. Credit data rebounded somewhat in March, but the BLS is pointing to a significant weakening going forward, and the credit impulse looks consistent with a meaningful contraction in euro area GDP already (although the 10% contraction in real M1 growth is likely to significantly overstate the effect of tighter monetary conditions on activity).
Don't get us wrong, credit tightening is a feature, not a bug of ECB's policy normalisation. So far, this tightening has remained orderly, but monetary transmission is working, with more to come.
Meanwhile the flash HICP report for the month of April did not bring any meaningful surprise except for a small uptick in headline inflation that is going to be reversed.
Core inflation is still too high but it eased slightly for the first time in almost a year, from 5.7% to 5.6%. The improvement was driven by lower core goods inflation (easing 0.4pp, to 6.2%), but services inflation reached a new high of 5.2% in April.
Clearly, the ECB will need to see more evidence of easing price pressures before it stops hiking, but at least direction-wise leading indicators are moving in the right direction. Various measures of underlying inflation started to stabilise in March, including median and super core.
True, wage growth will be rising at a fast pace in coming quarters, including some eye-catching wage deals in Germany, but this is the mother of all backward-looking indicators and the outlook for 2024 and beyond looks less worrying.
In the end, a downshift to (a series of) 25bp rate hikes looks likely as a compromise. The more hawkish members of the Governing Council could push for a faster pace of balance sheet reduction starting in Q3, up from the €15bn monthly reduction in Q2, but either way the pace of Quantitative Tightening will be capped at about €30bn as long as the ECB keeps reinvesting the proceeds of its Pandemic QE programme.
The ECB may also discuss the upcoming TLTRO redemptions, with nearly €500bn set to be paid back by banks at the end of June. While this may not be a problem in the context of €4,000bn aggregate excess liquidity, the ECB will be monitoring the situation of the most vulnerable banks, with the objective to prevent any idiosyncratic issue and constraints on loan supply. An ad hoc bridge LTRO operation cannot be completely ruled out, although it would have to be offered at more punitive interest rates in the context of policy normalisation.
What next? If the Fed does pause after May and the US economy enters a recession in H2, it remains to be seen how long ECB and Fed monetary policies can diverge.
There is a case for this divergence to be sustained for a little longer than what history would suggest. First, we don’t forecast a recession in the euro area as activity remains supported by strong services, resilient labour markets, and limited fiscal drags. Second, a strong euro would not be a major problem for the ECB – on the contrary, it would help reduce the pressure from imported goods inflation. Lastly, we don’t expect the Fed to cut rates this year – if they did, this would likely be on the back of a much weaker economic and inflation environment, which may also lead to a reassessment of the European outlook.
In all, we continue to expect the ECB to hike rates by 25bp in May, and by another 25bp in June, bringing the deposit rate to a peak of 3.50%, with risks skewed to the upside.
