About the ECB’s ‘About Face’

While the ECB did nothing at last Thursday’s meeting, ECB President Christine Lagarde’s talk seemed to reverse course from her prior “dovish” statements about inflation. Before Thursday, Lagarde argued fast-rising prices were temporary and passing. Now she says inflation is “tilted to the upside” and could stick around for “longer than expected.”^[i] This rhetorical shift sparked speculation the ECB will soon embark on rate hikes, when it signaled previously it would stand pat this year. Yet—oddly—the data that likely helped motivate the switch also argue against it. This highlights, once again, that the ECB’s guidance isn’t actually that reliable. It also illustrates the folly of trying to predict what central banks will do, no matter how “data dependent” they claim to be.

Unexpectedly higher inflation likely contributed to the ECB’s changing its tune. Headline eurozone inflation hit 5.1% y/y in January—up from 5.0%, above consensus expectations for a retreat and a record high.^[ii] This comes against the backdrop of persistently high inflation rates globally and central banks’ increasingly taking action—and mounting pressure from some eurozone officials to follow suit. But there is a big, big caveat to that high headline figure: Energy prices, which accelerated to 28.6% y/y, remain the big driver.^[iii] “Core” inflation, which excludes food, energy, alcohol and tobacco, slowed to 2.3% y/y, moderating from December’s 2.6%.^[iv]

Now, the ECB targets headline inflation, not core. But central banks fairly regularly look through rising prices when the drivers are volatile and narrow. Actually, the ECB has been doing that since last July, when headline inflation breached the bank’s 2.0% target. It isn’t clear why this particular data dump prompted the shift. The ECB could easily change its mind again, whether or not the data shift as well. Monday, Lagarde was back to downplaying inflation, saying: “There are no signals that inflation will be persistently and significantly above our target over the medium term, which would require measurable tightening.”^[v] What to make of the latest ECB-speak? We can’t tell—nor can anyone else.

Curiously, while acknowledging fast-rising energy prices’ economic impact, the ECB didn’t mention the divergence between core and headline inflation rates when expressing “unanimous concern” about rising prices. Why is harder to know than what, but this appears like a case of a central bank trying to optimize politically. To us, this resembles the “Powell Pivot” back in November, when Fed head Jerome Powell dropped the word “transitory” from his inflation vocabulary—for clarity’s sake, not necessarily that he thinks high inflation will be lasting. More recently, consider the flak Bank of England boss Andrew Bailey drew Thursday, suggesting workers shouldn’t ask for pay raises in order to restrain inflation. Explaining away what is hitting folks in the pocketbook isn’t a good look with the public or the press. Central banks have long had a tough political line to walk. Most observers thought Lagarde’s diplomatic credentials were why she got the ECB’s presidency despite lacking monetary policy experience.

Politics aside, we see a few implications here for investors. This episode shows yet again why monetary policy isn’t predictable nor central banks’ forward guidance ironclad. Their forecasts—and actions—often shift with public opinion. The data they supposedly depend on don’t act as guidance so much as after-the-fact rationalizations when they suit their chosen narrative. They aren’t compasses, but weathervanes—nothing to go by. Investors are better off just waiting to see what central banks do, as markets have no preset reaction to monetary policy anyway. Trying to navigate their decisions ahead of time is futile and could very well be counterproductive.

Besides, rate hikes have no power over current price drivers. They won’t increase energy supply, pacify Russian “President” Vladimir Putin or address supply chain wrinkles, as Lagarde recognizes. That said, if the ECB does move away from negative interest rates, which distort banks’ lending incentives, so much the better. Less negative short rates may even be somewhat more accommodative, as they would enable banks to stop charging for deposits, which is inherently contractionary. That is overwhelmingly what matters to the economy—the overall flow of money and credit. Not noncommittal and subtle (or indecipherable) hints from monetary policymakers or incremental interest rate moves.