by Shaun Richards
The last week or so has seen a bit of a change in bond markets and some of it has come from the rhetoric of central bankers as we set yet more open mouth operations. Today Isabel Schnabel who is often the face of ECB open mouth operations has been interviewed by Reuters.
At first we see her heading in the opposite direction as she mulls problems for Euro area economic growth.
The euro area economy is clearly slowing. Some of the downside risks that we identified in June are now materialising. Indicators like consumer or business confidence have declined further. The Purchasing Managers’ Indices (PMIs) have dropped notably, not only in manufacturing but also in services.
As an aside she is confirming that they rely on the PMI series and have much more faith in it that I do. However even it is sometimes correct. She is worried about the end of the year.
One source is pent-up demand, which shows up particularly in services; tourism has probably been especially strong. This is likely going to carry over into the third quarter but it may fade towards the end of the year.
The next bit is especially interesting when we note what we were only recently told and the emphasis is mine.
Nevertheless, there is a strong indication that growth is going to slow and I would not rule out that we enter a technical recession, especially if energy supplies from Russia are disrupted further. Downside risks to economic growth have also increased due to additional supply-side shocks, caused by droughts or the low water levels in major rivers.
Less than a month ago at the latest policy press conference ECB President Lagarde told us this.
Under the baseline scenario there is no recession, neither this year nor next year.
The mention of the issue meant that Isabel was pressed about it.
I do not see any indication of a prolonged, deep recession at the moment. It’s not even clear that there’s going to be a technical recession in the euro area at all. I would just not rule it out.
Of course she was one of those who assured us that there wouldn’t be any inflation. From October 7th last year.
I will begin my remarks by briefly discussing how the current spike in inflation can in large part be attributed to temporary pandemic-related factors that are likely to dissipate in the medium term. …….
She assured us it was heading for 2% back then..
On the contrary, recent developments across indicators suggest that investors and professional forecasters are increasingly internalising our new monetary policy strategy as well as our recently revised forward guidance, bringing us closer to our inflation target of 2 percent.
Whereas now she tells us this.
Headline inflation in the euro area increased again in July and now stands at 8.9%.
Yet we then see typical central banker behaviour which is to cling to the signals that have just proven to be useless.
It’s a broad-based development. If you look at any of our measures of underlying inflation, they are moving up further and stand at historical highs.
Of course there is the obvious problem that “temporary” has morphed into “broad-based” and “moving up further”. As to the next bit the response is, you don’t say…
But forecasting has proven quite hard in recent years and our staff are continuously working on improving the economic projections.
It funny how we managed to predict inflationary pressure isn’t it?
Now we see another U-Turn and it is in an area I predicted.Last year we were told this.
In other words, there is currently no indication that elevated inflation rates are becoming entrenched in medium and longer-term inflation expectations in the euro area, entailing risks for price stability.
So actual inflation does not matter but expectations ( as measured by the central bank) do.Whereas now we are told.
This speaks in favour of giving more weight to actual inflation outcomes in monetary policy decisions…….Inflation projections play a key role in our monetary policy decisions. But we should not ignore what is happening at the moment.
The problem is that they did and the inflation genie is now out of the bottle. The reason I had very little faith in inflation expectations is back to the difference between theory and reality. In theory they should work like the ECB expected but in practice the markets are illiquid and were often distorted by all the QE bond buying. They gave the answer they wanted to hear not what was likely.
The next bit if it wasn’t so sad would be comedy.
Most measures of longer-term inflation expectations remain around 2%. However, a number of indicators are pointing towards an elevated risk of de-anchoring. If you look at our household survey, the Consumer Expectations Survey, we can see that the median expectation of inflation three years ahead has edged up after having been anchored at 2% throughout the pandemic.
Firstly we have just been told that we are not going to obsess about inflation expectations again. But even more importantly how can you miss the obvious reality that the Survey has completely missed the inflation surge and is in fact worse than useless as it encouraged central bankers like Isabel in their complacency and group-think?
Implications for interest-rates
This is where I return to the theme that I started with which is a shift back towards higher bond yields. The two-year yield in Germany was 0.51% yesterday morning but is 0.75% now. So far Isabel has given us something of an each-way bet or if you prefer the classic economists response. On the one hand we see a weaker economy ( lower interest-rates) and on the other we see more inflation ( higher interest-rates)
She did address this more directly. First a hint of another 0,5% increase in September.
In July we decided on a 50 basis point hike in light of the inflation outlook. At the moment I do not think this outlook has changed fundamentally.
Also there was this.
Still, even if we entered a recession, it’s quite unlikely that inflationary pressures will abate by themselves……….The growth slowdown is then probably not sufficient to dampen inflation even if it reduces the price pressures due to slowing demand.
Also in response to this.
Markets price about 110 basis points of rate hikes this year and a total of 145 basis points until the peak of the cycle. Are you comfortable with those expectations?
We got this.
The broad direction of policy is pretty clear, but we don’t want to give particular guidance due to the high level of uncertainty.
So she has not denied the suggestions which is the crucial part. Just for clarity the two-year yield is not predicting those increases and it would be an excellent question to ask why not?
Comment
As you can see the ECB is trying to influence expectations again especially if we assume the speech was leaked. That is not as far fetched as you might think as it has come under fire before for having discussions with hedge funds and the like in private.
But these things end up having more holes than a Swiss cheese. Let me give you another example.
We do not comment on the level of the exchange rate.
Here is ECB President Lagarde from the July 21st press conference.
And, added to that, which relates, essentially, to inflation, the euro/dollar rate that has fallen substantially in the last few weeks, which obviously has a bearing on inflation going forward.
Also there was something which caught my eye because quite a bit of social media assures us that only the UK has a labour shortage. Back to Isabel.
We also have a very strong labour market. We see continued acute shortages of labour, historically low unemployment and a high number of vacancies
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