A Hawkish Cut. The ECB has cut rates, as expected, while the inflation forecast was revised up. The upward revision of the inflation forecast was unsurprising (given acquired inflation in 2024), although we assumed could come in September. Considering the cut-off date for the June projection (May 15th) and the persistency of HICP services inflation, the risks are high for another upward revision in September and a skip/pause in cutting. Stepping back, we think it is pretty clear the intention of the Governing Council: a hawkish cut (steepener). Having said that, we continue to think that the GC members are likely understimating the risks. Indeed, as we explain below, the new forecast assumes that core HICP prices will grow 3½% ar in the remaining 7 months of the year. While it went under the radar today, believe it or not, the ECB has cut rates while assuming that core inflation will continue to growth sequentially well above 3% (ar) in the foreseeable future. Quite frankly, we would have not believed it back in the old days.
The new forecast
A more realistic forecast, likely to remain under pressure going forward. Figure 1 shows a comparison between the new ECB/NCBs staff forecast and our own. Overall, it is unsurprising that the data have forced the staff to revise up the forecast, given the level of acquired inflation. Having said that, we expected the revision at the September meeting more than now, considering that the cut-off date was May 15th (therefore, it did not include the May flash release). In any case, we continue to suspect that the ECB/NCBs staff (and the GC members, see below) are underestimating the level and persistency of HICP services inflation and that the risks are to the upside from now until September.
Cutting with sequential core at 3¼-3½ percent (ar)? Even if the new forecast will prove correct, there is a detail that is quite puzzling to us. In fact, for the YoY of core HICP to average 2.8% in 2024, it implies an assumption of the average MoM in the remaining 7 months of the year of around 27-28bps (or around 3¼-3½% at annual rate). Let’s take a moment to think about it: the ECB has cut rates assuming that core inflation will grow 3½% ar in the next 7 months with services running around 4% ar. Quite frankly, we would have not believed it back in the old days.
Figure 1. Comparison ECB/NCBs staff vs UnderlyingInflation forecast.
The Q&A – Review
Question: Why did you cut while raising the inflation forecast?
Lagarde: “So let me explain to you why our confidence has increased in the path ahead. And I will take you back a little bit, because this is, after all, the first time in many years that we make that kind of decision. And these things do not happen in a vacuum. So, I’ll take you back a little bit to our monetary policy cycle to remind you that we have had two successive phases, and we have made that decision. So, the first phase, as you will remember, was a phase of very robust and rapid tightening. We tightened by 450 basis points between July ‘22 and September ’23. Then, we moved into a phase of holding from September ‘23 up until today. And if I look back, and we look back at those phases, during each of those phases, we divided inflation by half. So, if you look at the peak of inflation, October 22 we were at 10.6%, double digit inflation on average. Now fast forward September ‘23 we are at 5.2. Fast forward to today, we are at 2.6%. So, at each and every step of the way, when […] we decided to move in a different direction we had halved inflation. I think the second element that we took very much into account was the reliability and the strength of our projections. And there is one particular line of projections which to many of us, was relevant. If you look at Q4:25 projections, you look at September, you look at December, you look at March, you look at June. There’s a variation between those projections of 0.1%. So it’s either 2.0% or 1.9% or 2.0% of 1.9%. And it’s on the basis of this reliability and solidity and robustness of those projections that we have made that decision to actually cut.”
Comment: Well, President Lagarde I have bad news. If your confidence comes from the fact that the inflation forecast in a given quarter at the end of the forecast horizon has not changed much, we need to talk. Indeed, while impossible to know given the cumbersome procedures of the ECB staff, it is likely that the forecast converges back to 2% by construction (in the staff models). Therefore, to us, one should take little confidence from that. Not only, but while headline HICP has clearly moderated as a result of lower energy prices, HICP services inflation, the “trend” of inflation has not. In fact, so far in 2024 it got marginally worse than in 2023 (Figure 2 below) and certainly way worse than in 2022. Therefore, President Lagarde, we have a question: are you, the GC members, and the staff aware at all of the evidence below?
