Morning Brief – Blinkers

Charles Porter
Thu 2 Feb 2023


Today is the day that the ECB and Bank of England meet. Spreads in the spot, forward and options markets are all reflecting a degree of uncertainty and exhibiting volatility already. As we have mentioned, both central banks are widely expected to pursue a 50-basis point hike but the higher conviction call within these two decisions has been with the ECB. That’s a summary of the events to unfold later today, however, I want to focus on the Eurozone and how it may potentially be moving with the market and trend to raise rates in the face of inflation despite fundamental signals from the economy that this might not be the right policy path. The Eurozone has demonstrated a commitment to raising rates by 50-basis points at today’s meeting. Since such comments, growth and proxy growth data for some core Eurozone economies has been strong, sustaining the expectations for the above average sized hike in rates. 

The ECB’s rhetoric towards continued policy adjustments has come despite a proven success in taming inflation. Just like most of the recent and widespread inflationary pressures, inflation in the Eurozone has been caused by rising commodity prices triggered largely by the Russian invasion of Ukraine and supply chain constraints post-Covid. However, unlike in the UK for example, prices are no longer rising and over a shorter horizon they are in fact falling. Year-on-year inflation data still looks scary, sure, of course they do. However, let’s look at the price level change from October to November, November to December and December to January. The price level actually fell in those three months by 0.1%, 0.4% and a further 0.4% respectively. Over the short term there is therefore disinflation in the Eurozone, not inflation. That begs the question of what the ECB could be doing to the prospects of the Eurozone economy in the year(s) ahead.

If this adjustment in prices occurred whilst interest rates remained on the rise but lower than present levels, then there is serious concern for the future of the Euro area’s price stability if the ECB continues its hiking path. Without a doubt, there are seasonality effects to consider and the fact that energy prices remain uncertain, however, if the Eurozone was achieving 0.4% price level contractions consistently, that equates to an annualised rate of 4.9% disinflation. If the ECB is hiking a further 50 basis points, it is logical that this rate of disinflation could accelerate. Once year-on-year comparison catches up to a more recent point in time that wasn’t characterised by such spikes in inflation as they are in today’s observations, the ECB could quickly wake up to a disinflationary environment. That would leave the ECB with a lot of remedial action to unwind its 2022/3 monetary policy adjustments with a significant dent to growth and financial growth to show for this episode. If disinflationary conditions remain, the Euro could be in for a record collapse later this year. However, much of this will depend upon external conditions including the path of energy prices to determine the trend in the price level in the months ahead.

Discussion and Analysis by Charles Porter

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