The European Central Bank has been accused of trailing behind other major central banks by failing to begin tightening policy, despite inflation in the eurozone reaching record highs.
A little under an hour after the Bank of England announced it was raising rates for the second time in a row, the ECB confirmed no change to its -0.5% deposit rate or its bond buying programme.
Central banks in major developed markets have all taken flak for their communication missteps around inflation expectations.
It was only in November that Fed chair Jay Powell finally retired “transitory” as a descriptor for the fast pace of price increases, at which point the US Consumer Price Index had already soared above 6%. As of December, it hit 7%.
BoE governor Andrew Bailey was accused of playing the “unreliable boyfriend” in November over his confusing communication, after publicly signalling a potential rate lift-off, only to double back.
But in the intervening months, rampant inflation has forced both central banks’ hands, prompting them to begin the process of quantitative tightening.
See also: Bank of England hikes rates to 0.5% as cost of living crisis spirals
Lagarde’s hawkish U-turn spooks markets
Similarly, Lagarde has also been caught out by the latest inflationary data points, forcing her to adopt a more aggressively hawkish tone. A day before the ECB meeting, it was revealed consumer prices in the eurozone rose by a record 5.1% in January.
During Thursday’s press conference, Lagarde admitted the ECB had “unanimous concerns” about the swift rise in prices and left the door open for a rate hike in 2022 on the basis the “situation had changed”.
The hawkish U-turn spooked markets, triggering a sell-off in sovereign bonds and pushing the Euro Stoxx down 1.9% by close of trading.
Meanwhile, the euro jumped to a two-week high against the dollar.
‘No rate rise, no change to asset purchases’
“Despite record inflation and record low unemployment across the eurozone, the ECB Governing Council decided to stand pat,” says David Roberts, head of Liontrust’s global fixed income team.
“No rate rise, no change to asset purchases which are expected to continue at a pace between €15-30bn per month until March 2023.”
Though Roberts notes Lagarde “did her best to sound a hawkish tone” by pointing out inflation was “much closer to target” than it had been, he says this was unlikely to offer reassurance.
“Pedants would point out that with inflation currently over 5%, it is much further from a 2% target than the 1.5% we had pre-pandemic.”
Bluebay Asset Management senior portfolio manager Kaspar Hense says Lagarde delivered “another poor performance”.
“She failed to master the difficult task she was given today once again. She didn’t push against market pricing, nor did she make clear that current inflation in Europe is rather supply-side related as she was portraying in her speech,” he says.
“It would not be a surprise if not only Philip Lane but she herself has to address markets again within the coming days and soften the hawkish tone which clearly upset markets.”
ECB behind the curve
The ECB’s reticence to raise rates has frustrated and perplexed investors.
“While the Bank of England decided to act today, the European Central Bank has just shown it is behind the curve when it comes to responding to the sharp rise in inflation,” says Paul Craig, portfolio manager at Quilter Investors.
“Just this week, we saw eurozone inflation spike to record highs and pile the pressure on Lagarde to push ahead with interest rates. They, however, continue to resist and risk causing themselves a further inflation headache given the euro is also depreciating.
“We were expecting Europe to have a strong year economically given the region has been removing Covid restrictions and will likely experience a popular holiday season. However, failing to acknowledge inflation now, risks greater action required later, which could stall the recovery.”
Europe seeing less inflationary pressures than US
But compared to the US, and even the UK, Europe is seeing less inflationary pressures, notes eToro global markets strategist Ben Laidler. Core inflation in the region is a little over 3% compared to the US where it has reached 5.5%.
On top of this, key economies like Germany and Spain have not yet fully recovered from the Covid-led downturn, which created serious headwinds for their auto and tourism sectors.
“This still-dovish interest rate stance is positive for European equities, and an important insurance policy on the economic rebound,” Laidler says. “European GDP growth is set to rival the US this year, something not seen in a decade. Europe’s more cyclical and cheaper equity markets are big beneficiaries of this. While low interest rates will keep the euro weak, this is a positive for the large number of international-focused European companies.”
Wage growth in the eurozone has also been “subdued”, notes Silvia Dall’Angelo, senior economist at the international business of Federated Hermes, which has somewhat justified the ECB’s “glacial approach to normalisation”.
“However, the ECB might want to buy some insurance against the risk of a price-wage spiral, in line with the playbook other major central banks have already been following,” she adds.
March ECB meeting will be key
All eyes will now be on the March meeting when the ECB will have fresh growth and inflation predictions and assess the pace of its asset purchases.
“A modest acceleration in the ECB’s plans for policy normalisation seems to be in the cards, but there is still plenty of uncertainty surrounding the outlook,” Dall’Angelo says.
“For this reason, ‘flexibility and optionality’ will likely continue to be the ECB’s mantra, and will remain available for use in either direction.”
Kempen Capital Management senior investment strategist Joost Van Leenders says Lagarde has remained consistent in basing decisions on conditionality.
“That pledge of no rate hikes in 2022 in December was based on what was known at that time. If the data and forecasts are different in March, the pledge may also change,” he says.
“Lagarde repeatedly said that the ECB will not hike rates before ending asset purchases, so the assessment in March will be very closely looked at. Lagarde’s press conference felt like she was preparing markets for a significant change in March. Rate hikes in 2022 now look much more likely, in my view.”
