Thoughts

March 03, 2023 | 14:59

Inflation Keeps the ECB Busy and the BoJ on Alert

Economist

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Do central bankers ever say to other central bankers “I told you so!”? I imagine that some members of the ECB’s Governing Council must be at least thinking it (inside voice!), particularly after this week’s shocking acceleration in the Euro Area’s core CPI to a record-high 5.6% y/y in February, when a slowdown was widely expected. The increase in energy costs over the past year has managed to seep into other areas and that will likely force the central bank to go further with its hikes, and hold rates higher for longer than the market was perhaps expecting. Until this week at least.

At the ECB’s previous meeting in February, there was “broad agreement” behind the decision to increase key interest rates by 50 bps, along with communicating the intent to repeat that move in March, depending on how the data fare. However, the accounts of that meeting revealed “reservations” were expressed about the forward guidance around March. Those who weren’t fully on board felt that there have been enough hikes (300 bps so far) to bring rates to a level that warranted some caution. Besides, “the risk of doing too much deserved as much consideration as the risk of doing too little”. Fair enough. But during this meeting, it was noted that short-term momentum in core inflation had already begun to decline. Obviously that has changed since that meeting four weeks ago. Even before the February inflation release, a number of Governing Council members had already voiced their openness for a May rate hike. They were more vocal this week, including those from Germany, Belgium, Slovenia and Estonia (granted, all land on the hawkish side of the spectrum). Now, with evidence that inflation is persistently high across much of the region (including Germany, France and Spain), we expect two more rate hikes of 50 bps each (in March and May), bringing the refi rate to 4.00%. There is a risk that it will not end there, but we will take this on a meeting-by-meeting basis.

The BoJ has been the tall poppy, although a little less so, after tweaking its 10-year JGB trading range last year. But inflation has yet to peak and is still double the official 2% target. The headline Tokyo CPI for February at least cooled from its 42-year high thanks to government assistance to lower utility costs, but core CPI is still at a multi-decade high. And the jobless rate unexpectedly fell in the latest month to a low 2.4%. Can the central bank keep ignoring these pressures? Incoming Governor Kazuo Ueda has been a little vague, but his most recent comments suggest he will be patient.

And from our Stephen Gallo, Global FX Strategist:

The EUR is deriving some support from short-term interest rates and expectations for further ECB tightening. Ultimately, however, EURUSD will be determined by Fed policy, energy prices, and investor risk tolerance levels. On the basis of those factors and at least 50 bps more of Fed rate hikes, expect EURUSD to drift higher over the balance of 2023, barring sharply higher energy prices or very uncooperative inflation on either side of the Atlantic.

The BoJ has a long history of being sensitive to fluctuations in the USDJPY exchange rate, and JPY appreciation in particular. BoJ gradualism is therefore the name of the game. That said, the domestic and global inflation backdrops mean the BoJ can’t fall much further behind its central bank peers without the JPY weakening beyond its comfort zone. USDJPY should drift modestly lower over the next couple of quarters if the BoJ follows through.