Monday, February 27, 2023
Question 1: How likely is it that peak headline euro area inflation is behind us?
Question 2: Relative to market forecasts of the ECB’s MRO rate peaking at 3.5%, which of the following is more likely during 2023?
Question 3: Under its current policy trajectory, with rates peaking at 3.5%, which of the following is most likely?
The February 2023 CfM-CEPR survey asked the members of its European panel whether inflation has peaked in the Euro Area and its implications for ECB policy. A large majority of 74% of the panel thinks that inflation has already passed its peak, but half the panel thinks the ECB’s rate will need to rise to above the 3.5% peak currently forecast by market participants to support the rate of inflation reduction. Consistent with this, more than a third of the panel thinks that the ECB’s current trajectory will have interest rates too low to curb inflation.
The February 2023 CfM-CEPR survey asked the members of its European panel about Euro Area inflation ECB policy to combat inflationary pressures.
The European Central Bank released its on 13th February 2023, presenting its growth outlook and inflation projections for the EU economy. In its Winter 2023 Economic Forecast economic forecast (February 13th), the ECB states that “three consecutive months of moderating headline inflation suggest that the peak is now behind us.” Inflation in the EU reached an all-time high of 10.6% in October 2022, declining to 8.5% in January 2023. It also revised its EU inflation forecast downwards to 6.4% in 2023 and to 2.8% in 2024. Moreover, the 5y-5y inflation-linked swap for the EU, a common measure of longer-term inflation expectations, moved in a narrow band around 2.3%, indicating that long-term inflation expectations have not de-anchored. Although core inflation still increasing, markets now expect policy rates to peak by mid-year. However, Felke and Philiponnet (2023) argue that while inflation pressures are expected to ease gradually going forward, they will not necessarily take place at an even pace throughout the EU. This makes it particularly challenging to ensure that the single monetary policy is effective throughout the euro area.
The ECB emphasizes that some key inflation risks remain. These include a resurgence of gas prices due to geopolitical tensions and increased demand from a post-lockdown China and higher-than-anticipated wage pressure due a tight labour market. Soldani et al. (2022) show how labour shortages have been on the rise in several advanced economies, which can tamper economic activity, aggravate supply bottlenecks, and trigger increases in inflation.
The ECB Survey of Professional Forecasters (SPF) also predicted similar inflation rates for the EU, with respondents (experts affiliated with financial or non-financial institutions based within Europe) revising their inflation expectations to 5.9% in 2023 and 2.7% in 2024. Bloomberg seconded the ECB’s views, arguing that “headline inflation has peaked [in the EU]” but mentioned that “core inflation will be stickier in the near term.” Credit Suisse expressed similar sentiments, stating “headline inflation may peak in Q4 2022, but core inflation is likely to hover around 5% until mid-2023.” Goldman Sachs echoed these views, stating that they expect inflation to ease faster than thought — to about 3.25% by the end of 2023 compared with earlier forecasts of 4.50%. Economists also forecast core inflation to slow down to 3.3% by the year-end as goods prices cool, but continued upward pressure is expected on services inflation due to rising labour costs. As such, given the “sticky” nature of inflation, Goldman expects the European Central Bank to remain hawkish in the near future.
van der Cruijsen, De Haan and Van Rooij (2023) provide another explanation for the ECB’s hawkish stance. They find that individuals who have higher inflation perceptions and those facing financial difficulties have lower levels of trust in the ECB. Given that van der Cruijsen and Samarina (2021) found that trust in the ECB facilitates better anchoring of inflation expectations, losing trust will make it harder for the ECB to bring inflation back to target. Hence, the ECB needs to reduce inflation as quickly as possible to reduce this erosion in trust and maintain the efficacy of its monetary policies.
The Policy Response
On 2nd February, the ECB decided to raise the key ECB interest rates by 50 basis points, bringing the interest rate on the main refinancing operations (MRO) to 3.00%. The ECB has maintained a markedly hawkish tone regarding inflation, with President Christine Lagarde stating saying “we have ground to cover” due to high core inflation rates. In its statement on February 2nd, the ECB stated its intention to raise interest rates by another 50 basis points in March and then “then evaluate the subsequent path of its monetary policy.” While acknowledging the concern regarding overtightening, Mario Centeno (Governor of the Bank of Portugal) stated that the ECB intends to have “at least” a few more rate hikes in 2023 to tackle inflation.
Similarly, the ECB SPF expected the ECB’s key MRO interest rate to increase to 3.0% in the first quarter of 2023 and to 3.5% in the second quarter of 2023, before easing slightly in 2024 and in 2025 to below 3%. Bloomberg Economics also expressed similar views, stating: “We expect this will keep the ECB hiking at least through Q1, 2023.” Oxford Economics also stated, “We think that falls in headline inflation will do little to stem the central bank’s hawkishness.”
Most banks believe the ECB will continue to hike interest rates beyond its intended 50-bp hike in March. Goldman Sachs sees “two further 0.25% rate hikes in May and June, implying a 3.5% terminal rate in the summer.” Some banks felt that the ECB wasn’t doing enough to anchor future inflation expectations and needed to clearly state its intention to hike interest rates by more than the planned amount. Commerzbank stated that they “continue[d] to believe that a deposit rate of about 4% is necessary”, while Société Générale claimed that the ECB is rather “taking the risk of doing too little than too much tightening to reach the target.” Nordea echoed these sentiments, claiming “Lagarde’s comments strongly suggest that the ECB is planning to continue rate hikes also beyond March.” ING also expressed similar views: “As long as core inflation remains stubbornly high and core inflation forecasts remain above 2%, the ECB will continue hiking rates.”
However, some other banks expect the ECB to adopt a more dovish approach and end its tightening cycle in March. ABN Amro “continue[s] to expect the deposit rate to peak at 3%, which implies that the 50 basis-point rate hike in March would be the final one and that rates will be kept on hold for a while after that.” Berenberg indicated similar sentiments: “As inflation looks set to decline, we expect [the ECB] to push back against further major rate hikes in the second quarter.”
This month’s CfM-CEPR survey asked the panel about the prospects for inflation in the Eurozone. It included three questions. The first asks whether inflation has peaked. The second asks whether the ECB will raise interest rates above 3.5%, as its MRO rate is currently projected to peak. The third question asks whether the currently projected 3.5% peak rate will be sufficient to curb inflation.