“An unrealistic forecast is an opportunity”. At the time of the March 2023 Governing Council (our note here), we wrote: “An unrealistic forecast is an opportunity. The question is simple: what will happen in June when the ECB [NCBs] staff will be forced to revise up (and probably not marginally so) its core HICP inflation forecast?” The June meeting is here and while most people and sell-side analysts seem puzzled about the large upward revision to core HICP, we are not. We discuss how we got it right, the implications of the new forecast, as well as the confusing (as usual) communication.
The ECB raised its core HICP inflation forecast and changed the narrative of the drivers. According to the ECB press release “Staff have revised up their projections for inflation excluding energy and food, especially for this year and next year, owing to past upward surprises and the implications of the robust labour market for the speed of disinflation. They now see it reaching 5.1% in 2023, before it declines to 3.0% in 2024 and 2.3% in 2025”. The change is significant not only because of the upward revision of core inflation but also because the ECB is finally admitting that the labor market is playing a role. This is what we have been trying to communicate for months: while the dominant narrative is that “it is all about energy prices / negative supply shock”, it cannot be. This has become apparent last December and obvious last February. We explain why in the next paragraph.
How did we get it right? It’s research and we take it very seriously. Here is the chronology of our Euroarea (most relevant) updates:
- Last December we circulated a set of slides (“Is Inflation in the Euro Area “supply-side” driven? A Micro 101 Analysis”) that were arguing that Euroarea core inflation was NOT driven only by negative supply shocks and that the role of demand shocks was as large as the supply-side.
- The above slides became a paper last March (“EA: “It is all About Energy Prices”, They Say. But it Cannot Be”) in which we have quantified the contributions of demand vs supply-side factors using econometric techniques. The result was the same: half supply, half demand.
- Last January (“US vs EA: ECB staff in “La La land””) we argued that the ECB staff and the high officers were in “La-La Land” and that they were wrong in their diagnosis.
- Last February (“Carry-Over Effect, Acquired Inflation: Why the ECB Staff Forecast is Implausible”) we explained why the ECB staff forecast was mechanically implausible using the notion of “acquired inflation”.
- Last March (“March 2023 Governing Council Meeting: How Wrong Can It Be? “ECB Staff Wrong””) we reiterated the message after the Governing Council.
We also reiterated the message in every email commenting HICP data: the ECB staff forecast was too low and the diagnosis was wrong. The truth is that the dynamics of inflation in the Euroarea have been (overall) similar to the United States. The truth is also that we went against consensus most of the times (indeed, it seems to us that the majority of people still think that “it’s all about energy prices”). Hopefully, the narrative will change now, given the explicit ECB statement.
(For the record, the 1y yield Bund is trading today at the top of this cycle. At the time of some of the notes listed above, it was 70-80bps lower..not to talk about BTPs)
The new forecast is more plausible but the ECB remains prone to additional upward surprises. Figure 1 shows our judgmental forecast (MoM sa) and the MoM consistent with the new 2023 ECB forecast (5.1%). Because of the significant upward revision of the ECB, the distance between the two lines is smaller than yesterday. However, the blue line remains well above the red line, signaling that the ECB could be upwardly surprised again going forward.
(It remains a mystery why after missing core inflation in the same direction for 2 years the ECB/NCBs staff do not revise up more their forecasts. But you know.. NFP!)
Figure 1. Revised core HICP forecasts (MoM, sa)
Lagarde’s communication was a mess as usual. We do have the transcripts (available upon requests) and we read them 3 times. But at the end of the day, we were unable to understand several things:
- What the ECB needs to see in core inflation to pause in September (Lagarde referred to a “whole variety” of measures of underlying inflation – choose your favorite, we guess).
- What is the terminal rate they have in mind (in our view, they have no idea and no guidance from the models for technical reasons we can discuss via email upon request).
- Why core inflation forecast was revised up. The truth is that the staff is finally realizing how late (and wrong) it has been. But Lagarde pointed to… the unit labor cost (!?). For the record, the forecast published today does not come from a specific model but it is a Frankenstein of the forecasts of the NCBs. Therefore, in our experience, determining the contributions of the revisions is virtually impossible (no framework, no idea).
- Whether the ECB thinks there is some sort of wage-price spiral. Lagarde said no-ish but admitted we are seeing a “tit-for-tat” and that core inflation is revised up because of the unit labor cost dynamics. Oh, key.
Bottom line: we can largely ignore the press conference.
Ignore the noise, focus on core HICP. At the end of the day, the only thing that matters is that the tone has been set by the large upward revision of core HICP inflation in the forecast. This is precisely what we expected. Right now, we are unsure whether this is the last time the data have forced the ECB/NCBs staff to revise up their forecast.
The really good news is that this is certainly not the last time we can tell you when they are wrong. And do it 6-8 months in advance.