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ECB Searching For A New Baseline

The European Central Bank is expected to step up its policy-normalisation process today with a 75bp rate hike. While we do see some downside risk of a 50bp move considering the traditional caution of the Governing Council, the scale of the move is probably beside the point. Growth expectations are so downbeat that even at maximum pricing of 75bp for this meeting and 2.50% for terminal rates, the euro has failed to hold onto parity versus the US dollar with energy shortages looking set to intensify in the near term.

On the policy path itself, the first note of caution for today is that the ECB may not have full details of the fiscal package to be launched by national governments and the European Union. A political consensus is building on using windfall taxes to fund supplements to household bills and energy price caps. We suspect this will need to account for up to 5% of EU household disposable income to materially avert energy poverty. This would be equivalent to a cumulative stimulus of up to 4% of Eurozone GDP over the next 18-24 months. For comparison, the anticipated package also due to be announced today in the UK, at £170bn, is equivalent to almost 7% of nominal GDP. If the Eurozone gets half close to that, the forecasts upon which current policy is determined may have a short shelf-life.

The ECB will also need to decide where its baseline is. Today's meeting will bring a new set of staff macroeconomic projections (SMP), and we expect them to look radically different from those issued in June. In that set, the SMP provided a ‘downside scenario’ of forecasts, predicated on the key assumption that there would be “a complete cut in Russian energy exports to the euro area starting from the third quarter of 2022, leading to a rationing of gas supplies, significantly higher commodity prices, lower trade and intensified global value chain problems." Suffice it to say that the “complete cut in Russian energy exports” condition has been fulfilled, though high levels of reserve capacity achieved earlier than scheduled in key Eurozone economies suggest the ‘rationing’ condition remains open to debate.

Under the downside scenario, Eurozone growth in 2023 collapses from the 2.1% baseline to -1.7%; a third of the cumulative 3.8pp decline is attributed to production cuts, and the rest is due to the impact of other secondary channels. Even if the indirect channels are softer than expected, Eurozone growth would be close to zero.

We believe it will be extremely difficult for the ECB to hazard any form of rate-based tightening with such a deep contraction in growth. However, as shown below, the market’s consensus forecasts are not yet as pessimistic, as very moderate growth is expected for 2023. Forecasters for now could be awaiting further guidance from the ECB and September SMP, but as the direction of travel is clearly for strong fiscal intervention, there is reason to reserve judgement. What could prove difficult to calibrate is that even if household energy bills are frozen, the lack of energy supplies will have an impact on production. As the Eurozone is not a consumer-driven economy, the growth boost from protecting households would likely not be as strong as a similar programme for the UK. Ultimately, we see some upside risk to the -1.7% downside view after national and EU programmes are announced, but a heavy discount from the June baseline SMP for 2023 growth would seem required.