This year is turning out to be the perfect storm for the doves who proposed looser monetary policy within the ECB Governing Council. "Transitory" had been their description of inflation; now it is unspeakable. Not only are the inflation numbers still rising in the Eurozone, but the worry for central bankers is also that inflation will remain high for a long period of time. Europe’s position is similar to the U.S., where core inflation has been declining since February but at a very slow rate. And yet the Fed is many steps ahead in its rate hike cycle compared to the ECB. Moreover, its chairman, Jerome Powell, stressed in the Jackson Hole meeting on August 26 that the Fed will resolutely continue on the tighter monetary path.
DWS’ economic and market forecasts
* FR=France, MT=Malta, FI=Finland, LX=Luxembourg, DE= Germany, IE=Ireland, IT=Italy, EZ=Eurozone, AT= Austria, PT=Portugal, CY=Cyprus, ES=Spain, BE=Belgium, GR=Greece, SL=Slovenia, SK= Slovakia, NL=Netherlands, LV=Latvia, LT=Lithuania, EE=Estonia
Sources: Haver Analytics, DWS Investment GmbH as of 8/31/22
In our view the ECB will have to follow.
Preliminary inflation figures presented on Wednesday confirm our pessimistic European inflation picture, with a GDP-weighted inflation rate of 9.1%. As our Chart of the Week shows, almost half the euro countries were already suffering from double-digit inflation in July. The Baltic states, with their more flexible factor markets, have even hit rates of over 20%. Each member country has one vote in the ECB Governing Council. And every single governor will hear inflation misery stories from home, which he will find hard to ignore: inflation always hits the poorest hardest.
ECB Board member Isabel Schnabel is likely to be receptive. She delivered a remarkable speech, also in Jackson Hole. We reproduce the most important passage unabridged: "There are two broad paths central banks can take to deal with current high inflation: one is a path of caution, in line with the view that monetary policy is the wrong medicine to deal with supply shocks. The other path is one of determination. On this path, monetary policy responds more forcefully to the current bout of inflation, even at the risk of lower growth and higher unemployment. This is the “robust control” approach to monetary policy that minimizes the risks of very bad economic outcomes in the future. Three broad observations speak in favor of central banks choosing the latter path: the uncertainty about the persistence of inflation, the threats to central bank credibility and the potential costs of acting too late."
If this is the view that wins majority backing on the Governing Council, the market's expectation that the peak for ECB policy rates is 2.25% next year may prove to be too low.