December ECB meeting preview: Pushing back against early rate cut speculation

In line with the October meeting, investors are confident that this Thursday’s ECB announcement will leave key interest rates on hold. Indeed, further warning signs of an impending Eurozone recession together with a surprisingly steep fall in inflation have left most forecasters more focused on when the first cut might be delivered in 2024 and how many there might be. No change would leave the deposit rate at September’s record high of 4.0 percent, the refi rate at 4.50 percent and the rate on the marginal lending facility at 4.75 percent. However, while financial markets ponder the probable easing profile next year, expect the ECB to reiterate in no uncertain terms that current levels will have to be maintained for some while to ensure the timely return of inflation to target.

As it is, policy continues to be tightened through QT. Net sales from the asset purchase programme (APP) were €17.9 billion in November, boosting cumulative disposals since February to just over €213 billion and leaving holdings (€3.04 trillion) at their lowest level since the middle of 2021. For now, the pandemic emergency purchase programme (PEPP) remains outside of QT and full reinvestment of maturing assets is still scheduled through at least the end of 2024. However, with key interest rates having almost certainly peaked and bond yields around 60 basis points below where they were at the time of the October meeting, the hawks on the Governing Council (GC) will be all the keener to see it included. There may be some hints on Thursday about a shift to partial reinvestment next year.

Either way, financial markets have become much more aggressive in their expectations for interest rate cuts in 2024. From currently about 4.0 percent, futures now price 3-month money rates as low as 3.30 percent by next June and only just over 2.60 percent by year-end, the latter more than 75 basis points below that anticipated just before the October meeting. On the basis of these projections, the ECB could be the first of the major central banks to start easing and would deliver fully six 25-basis point cuts over the coming 12 months. Such aggressive pricing will not sit well with most GC members.

Strongly negative base effects were always going to cause a sharp fall in inflation in October but the actual decline was surprisingly steep. November’s flash report followed a similar pattern, leaving the headline rate (2.4 percent) at its lowest level since July 2021 and the narrow core rate (3.6 percent) at its weakest mark since April 2022. Even ECB board member Isabel Schnabel, a moderate hawk, described the fall as remarkable. The broad-based deceleration almost certainly rules out any more rate hikes and could also mean that the ECB will trim its inflation forecast in Thursday’s updated projections. Immediately ahead, overall inflation is set to increase this month as, unusually, prices fell in December 2022 but the core rates could still ease further. All that said, the slowdown in the ECB’s own indicator of domestic inflation – which excludes items with a high import content – has been less marked, reflecting the fact that prices are becoming increasingly driven by domestic rather than external sources. To this end, although the contribution of profits, a key factor pushing up inflation earlier in the year, is now weakening, wage pressures remain strong and pay negotiations next quarter will be watched especially closely.

Moreover, despite the fall in actual inflation, the downtrend in expectations appears to have run its course. With demand still contracting, manufacturing is not a problem and, according to the EU Commission’s November survey, firms anticipate raising prices over the next three months by the least in three years. However, household expectations have started to trend higher and, of particular importance to the ECB, services are planning the largest increase in six months. The bank’s own survey, released just last week, showed consumers putting the 3-year ahead rate at 4.3 percent, up a tick from last time and matching an 11-month peak.

In terms of the Eurozone real economy, there has been little good news since the October meeting. Total output contracted, albeit by just 0.1 percent, in the third quarter and forward-looking indicators suggest that recession might well have arrived by the end of the year. Business and consumer confidence are at best flatlining at historically weak levels, retail sales are still trending down, M3 growth remains negative and the housing market, notably in Germany, is increasingly suffering the fallout from earlier ECB tightening. At the same time, a soft global economy is providing little support for exports which have fallen every quarter so far in 2023. Still, for now it looks as if any downturn will be relatively mild, not least because at 6.5 percent, the unemployment rate is just a tick above June’s record low.

For much of the period since the October meeting, overall economic activity has performed much as expected. Hence, Econoday’s relative performance index (RPI) has, until very recently, oscillated quite closely around the zero mark. However, there is now a sizeable gap between the RPI which, at minus 6, shows a limited downside bias to the data and its inflation-adjusted counterpart, the RPI-P which, at 12, shows the real economy modestly outperforming. Significantly, the difference reflects the fact that the downside shocks have been concentrated in the inflation reports which, from a policy perspective, should sit very nicely with the central bank.

Indeed, the recent surprisingly steep and broad-based decline in inflation should be enough to ensure another unanimous vote for no change in policy rates this week. In fact, combined with the sluggish state of the Eurozone economy, some GC doves will likely view the drop as warranting an earlier start to the easing cycle. Even so, for now the central bank’s message is likely to be that inflation is still too high and borrowing costs need to stay at current levels for some time to bring it back to target. That said, absent a sizeable upside inflation shock, investors are unlikely to agree.