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ECB projections don’t capture recent financial market volatility

Shortly before the policy announcement, Bloomberg reported that Luis de Guindos, the ECB vice president, had spoken to the Eurogroup of finance ministers early in the week. The article said that Mr de Guindos had told finance ministers European banks do not have significant exposure to SVB, but admitted European banks would be vulnerable to the impact of high interest rates and policymakers had to be mindful of potential contagion from a loss of confidence. When asked about his reported comments, Mr de Guindos said European banks are ‘resilient’.

Alongside its policy announcement, the ECB published its updated staff macroeconomic projections. The projections, finalised in early March, do not incorporate the effects of recent financial-market volatility. The revised figures show that ECB staff have increased their projection for real GDP growth in 2023 (to 1.0% from 0.5% in December) and have cut their projections for real GDP growth in 2024 (1.6% from 1.9%) and 2025 (1.6% from 1.8%).

The projections also show a lower profile for headline CPI inflation over the forecast horizon, principally reflecting lower energy prices. Core inflation, which excludes food and energy, is expected to be higher in 2023 but to then fall back sharply in 2024 and 2025 reflecting the impact of higher interest rates, a slightly stronger euro and, as a consequence, weaker demand.

Policymakers increasingly favour data over projections

Over the last few quarters, the ECB has effectively downgraded the significance of the projections in its policy decisions. Policymakers have become less confident in their inflation projections and have focused more on actual inflation data. They have used this approach to justify a significant policy tightening in recent quarters. Recent market turbulence has increased the uncertainty around the projections, weakening policymakers’ confidence in them even further. This implies they are having to balance the risks of higher inflation and greater financial instability as they set policy.

In her press conference, Christine Lagarde, the ECB president, said there was no trade-off between bringing inflation back to target and financial instability. Her view is that bringing inflation down would enhance financial stability. When asked about the potential policy path, Ms Lagarde said that, if the ECB’s baseline projections are accurate, they would imply more policy tightening. But she also acknowledged that recent market volatility had created more uncertainty around those same baseline projections. Against this background, Ms Lagarde was unwilling to give any definitive guidance on the policy path.

ECB follows the Bank of England’s path as markets react to tighter financial conditions

In justifying its decision to raise its policy rates today amid market volatility, the ECB is following a similar path to the Bank of England’s response to last autumn’s gilt shock. For now, the ECB clearly believes it can use different tools to address the challenges of stubborn inflation and growing financial instability risks.

Still, the recent turbulence in financial markets represents a tightening of financial conditions. This could aggravate the recent deterioration in bank lending in the euro zone and increase the downside risks to growth and inflation. In the UK, we saw this work through the channel of higher mortgage rates as lenders repriced after the spike in gilt yields. Inevitably, this contributed to the Bank of England’s admission that markets had become too aggressive in their expectations for policy rates. I believe we could expect a similar recognition from the ECB if markets remain volatile.

Implications for investors: How has it changed the outlook for policy rates?

The SVB shock and concerns around Credit Suisse has create profound uncertainty around policy paths. In the euro zone, the current tightening of financial conditions implies a lower terminal rate than investors might have expected before the events of the last week. It is possible we are now at –or close to – the terminal rate.

However, while incipient disinflationary forces and financial instability might curtail the tightening cycle, concerns about persistent inflation could mean central banks will maintain their terminal rates for longer.