ECB Preview: Forecasts from 10 major banks, more dovish direction as inflation trends to the downside

We expect the ECB to leave its policy rates unchanged. PEPP reinvestments may be discussed, but we don’t expect these to end cold turkey. We continue to see some risk of an increase in the minimum required reserves.

We see the central bank staying put. We now see the ECB cutting rates from April, with a risk of an earlier cut in March.

With headline inflation at 2.4% YoY and core inflation falling rapidly too, the ECB has nothing to worry about for now. We expect no change in policy at this meeting, and no material shift in tone from recent speeches.

The ECB is unlikely to signal any major policy changes in the near term. However, we would not rule out agreement on an earlier end to full PEPP reinvestments. The balance sheet remains too large, and it seems as good a time as any to pre-announce PEPP tapering as of March/April. We expect broadly neutral language, acknowledging the progress made on inflation but warning about calling a victory just yet. New forecasts should show inflation close to the target in 2025, opening the way for rate cuts in 2H24. Still, wage and productivity trends remain a concern and pose an upside risk to core inflation next year.

Our forecast is for the ECB to hold its Deposit Rate at 4.00%. While there is no change expected for the ECB benchmark interest rates, there will still be plenty for market participants to focus on. Eurozone growth and inflation have softened noticeably in recent months, including a decline in Q3 GDP and a sharp slowdown in November inflation. Amid this backdrop, there will be significant interest in the ECB's updated economic projections and, in particular, whether the medium-term CPI forecasts for 2025 drop to (or perceptibly below) the 2% inflation target. So far, ECB policymakers have signaled it is still too early to consider rate cuts. For now, we anticipate an initial ECB rate cut will occur in June 2024. However, a sharp markdown in the ECB's forecasts, along with a softening in the ECB's language, could increase the chances of an initial interest rate reduction coming as soon as the ECB's April monetary policy meeting.

The ECB meeting on Thursday looks more interesting given the sharp re-pricing in 2024 cuts and with PEPP likely to be discussed (and possibly decided). Of most interest to markets will be whether the ECB pushes back on the market’s ultra dovish pricing of ECB rate cut expectations that currently places it ahead of the Fed both on the timeline and amount of cuts priced over the next 2 years (EUR OIS rates fully price a 25 bps cut in March 2024 vs Fed’s 65% and 218 bps of cuts over the next 24 months vs Fed’s 210 bps). Markets will also focus on the ECB staff’s December economic projections for the euro area. The ECB is also likely to start discussing (and possibly decide on) PEPP QT this week, potentially driving 10yr BTP-€STR 5-15 bps wider. But while the discussion on ECB’s balance sheet normalization will likely gather speed, reserve scarcity is unlikely to be broached before 2026, at the very earliest.

Euro Area inflation is falling rapidly. We think, by early 2024, interest rates will have been held sufficiently high for sufficiently long for the ECB to feel inflation will return to target in a ‘timely manner’. We expect the Governing Council will start to cut interest rates in March 2024. By this time, the effects of monetary tightening will be weighing on demand, and monetary and credit aggregates are already contracting. The ECB may review and discuss the path of reinvestment in the Pandemic Emergency Purchase Programme (PEPP). Given current and expected inflation trends and monetary developments, we expect the ECB to proceed cautiously with any future changes, if at all.

Though many views are likely to be presented at the meeting, we think the ECB could turn more dovish in its communication, opening the door for a rate cut as early as in Q1 2024. Despite considerable intensification of rate cut expectations lately, a dovish ECB could feed a bond rally further. New staff forecasts could suggest inflation at 2% as early as late 2024.

The ECB is expected to hold key rates steady for the second month in a row, keeping the refi rate at a 22½-year high of 4.50%, the marginal lending facility at a 15-year high of 4.75%, and the deposit rate at a record 4%. New staff projections will help fine-tune the outlook for policy in the new year. Look for a more dovish press release, dropping the line that inflation is expected to remain too high for too long. The ECB now has two new CPI reports under its belt since that meeting, both coming in below expectations, with the most recent, November, showing inflation at a 2½-year low of 2.4% and core at a 1½-year low of 3.6%. The hawks won’t be fully convinced, though, as services CPI is still up 4% YoY, and one and three-year inflation expectations did not turn lower in the ECB’s latest monthly survey. So, to satisfy their demands, the key line about how rates need to be ‘maintained for a sufficiently long duration’ in order to ‘make a substantial contribution to a timely return of inflation to target’, or some form of it, will remain in the press release. But with France now joining Germany in contracting in Q3, and Q4 starting off weaker for the Euro Area, risking an official recession, the hawks will be careful not to be too loud with their warnings.

The ECB will probably lower inflation forecasts but is likely to push back against market expectations of imminent and rapid rate cuts. Nevertheless, we see headline inflation falling to 2% over the next several months which will open the door to rate cuts. We maintain our forecast that the ECB will start cutting rates in April and will lower them 6 times in 2024, leaving deposit rate at 2.5% at the end of next year.