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The ECB unanimously held the deposit rate at 4% at its final meeting of 2023, despite simultaneously downgrading its 2024 growth, inflation, and core inflation forecasts.

Instead, the central bank continued to point towards elevated levels of wage growth, such as unit labour costs which sit at 6.52% in Q3, to maintain its hawkish bias in its official communications. With the tone of the ECB statement and the adjustments to its projections not coming as a surprise, the main development today occurred in PEPP. With Lagarde stating in her intermeeting commentary that the Governing Council would look at making a decision on ending PEPP reinvestments ahead of their “until at least the end 2024” in due course, we didn’t expect today’s meeting to produce an official outcome.

In fact, under our base case, we didn’t expect an announcement until January’s meeting, with President Lagarde instead using today’s meeting to instruct a committee to look into the possible avenues. However, it seems that with the ECB already examining roll-off options for the APP programme in late 2021, the Governing Council was comfortable with a similar course of action this time around.

As a result, the ECB today announced that the stock of PEPP would be reduced by an average €7.5bn per month in the second half of 2024, avoiding the seasonal spike in bond issuance in Q1 and a bumpy redemption path in the first half of the year, before reinvestments would be ceased entirely at the end of 2024. This would see the total stock of PEPP reduced at an average pace of 0.43% per month,  not too dissimilar to the 0.46% drawdown during the APP taper between February and June 2023.

Overall, today’s decision looks to be a diplomatic one from the ECB. Acknowledging the cooling of the economy and the calls by some doves to begin considering rate cuts, ECB staff downgraded their expectations in 2024, while the newly minted 2026 inflation forecast was also placed below the 2% target at 1.9%, indicating that the discussion of easing is now becoming appropriate.

Counterbalancing this, the ECB noted that unit labour costs remained concerningly high for the first time in their communications, justifying the higher path for core inflation in 2025 and 2026. The hawks were also appeased by the earlier announcement on PEPP, even if its implementation remains some ways away.

Eurosystem staff downgrade inflation and growth forecasts for 2024 but continue to repel discussion of rate cuts

In contrast to the Federal Reserve, who on Wednesday propelled expectations of policy easing, the ECB aimed at keeping control of the market narrative at today’s meeting, pushing back on speculation of early policy easing in 2024. This was done through multiple channels, but most directly by President Lagarde stating that a rate cut wasn’t even discussed at this week’s meeting.

While the ECB’s ambition to delay any discussion on policy easing while simultaneously satisfying the hawks and the doves was effective at today’s decision, we think the central bank won’t be able to sit on its hands for much longer.

Headline inflation in the euro area is set to continue cooling at a considerable rate, while indicators for the labour market suggest normalisation is also occurring there too. Taken together with our view that the eurozone is currently undergoing a mild recession, a reality that should become increasingly clearer in tomorrow’s flash December PMIs, this should force the issue at the ECB, irrespective of another round of lagged wage and profit margin data. Our view remains that the central bank will need to begin easing in April with a 25bp cut at every subsequent meeting next year. This would culminate in 150bps of cuts next year, a scenario that markets have only just begun to trim the probability of today. For EURUSD, the latest round of pushback from the ECB should keep the pair supported above our year-end forecast of 1.07, largely because of the more accommodative US rates backdrop.

However, we think another sustained test of the 1.10 peaks reached in late November is unlikely unless there is a material uptick in December’s current activity data tomorrow. Under our base case of another weak round of eurozone data, specifically in current activity and employment sub-indices, it seems as if EUR traders are setting themselves up for disappointment yet again as economic reality bursts the sentiment bubble.

EURUSD climbs back to the 1.10 handle as the ECB’s resolute tone contrasts with a dovish Fed, but this could be traders setting themselves up for disappointment once again

Simon Harvey, Head of FX Analysis


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