ECB View: Subdued inflation outlook means central bank is focused on rates and wages – ECB President Christine Lagarde appeared yesterday before the Hearing of the Committee on Economic and Monetary Affairs of the European Parliament. The general tone of her remarks revealed a central bank that is still dissatisfied with a weak medium term inflation outlook and therefore wants to push back against a tightening of financial conditions.

Subdued underlying inflation – The current spike in inflation was still seen as being ‘largely owing to temporary factors’ and inflation was expected to decline ‘at the start of next year as temporary factors fade out’.

Underlying price pressures were expected ‘to remain subdued’ and it was noted that the ECB’s projection for inflation in 2023 was unchanged ‘at a level below (the) inflation aim’. Ms. Lagarde discussed the possible upward impact from rising inflation in the US (at the request of the Committee) which could come from rising imported inflation, stronger external demand and an upward impact on eurozone inflation expectations.

However, the conclusion of the ECB’s analysis was that ‘the effects on euro area HICP inflation are expected to be moderate’. In judging the inflation outlook, the ECB would be ‘very attentive to wage negotiations’. As noted in this publication last week, negotiated wage growth has slowed significantly.

Vigilance on rates – Against this background, the ECB President repeated the message from the recent Governing Council meeting that ‘a sustained rise in market rates could translate into a tightening of wider financing conditions that are relevant for the entire economy. Such a tightening would be premature and would pose a risk to the ongoing economic recovery and the outlook for inflation’.

She added that ‘as the recovery is gathering pace, we need to remain vigilant and ensure that policy support continues to provide a bridge over the pandemic and well into the recovery.’ Overall, the Governing Council (or at least the majority view) does not seem at all minded for an early exit from accommodative policy.

Meanwhile, she talked up the impact of the ECB’s lending programme to commercial banks, asserting that ‘TLTRO III is expected to contribute to increasing lending volumes by over 4 percent cumulatively and to lowering lending rates by more than 60 basis points’. These estimates appear rather bullish, but might be based on the impact compared to the counterfactual that the programme had not been put in place.

Strategy Review – President Lagarde did not provide any guidance on the outcome of the strategy review, but gave an update on the process. She informed the committee that ‘since all the issues covered in the seminars are highly interdependent, the remaining discussions will focus on deriving their joint implications for the monetary policy strategy. We made good progress during the retreat, and we will make the outcome of the strategy review public after taking formal decisions’.

Outlook for ECB policy – The September Governing Council meeting will be a significant one for the ECB. The central bank will likely announce the outcome of its strategy review. One of the key elements of that review will be a more ambitious inflation target (symmetry around 2%).

Therefore, the gap between its projection of inflation and its inflation goal will be larger. At the same time, it is likely to give a stronger signal that the PEPP will indeed likely end in March 2022 and will therefore have a challenge to manage market expectations that an end to the PEPP will not lead to early rate hikes.

The ECB could push back against these expectations by strengthening its forward guidance. This can be done by signalling much more explicitly that policy rates will remain on hold for a much longer period than markets expect. Alternatively, it could send the same message indirectly by signalling a much longer period of net purchases under the APP beyond (and perhaps with more flexibility and volume than currently) when the PEPP ends in March 2022.