The European Central Bank (ECB) acknowledged the progress made on inflation and left its policy rate unchanged at 4% in March. It did not discuss rate cuts. While the ECB again expressed increased confidence regarding inflation in the eurozone, the Governing Council (GC) refrained from declaring victory. It instead highlighted the need to remain attentive to the different forces affecting inflation and focused on bringing it back to its 2% target.

More than three 2024 cuts have been priced out since late last year and market pricing seems more reasonable as a result. At close to four rate cuts this year, market pricing is currently not far away from our baseline expectations of three cuts in 2024; hence we remain somewhat skeptical versus the market. This skepticism is based on “sticky” services inflation, a resilient labour market, loose financial conditions, the potential for renewed supply chain disruptions, and ECB risk management considerations.

Given the ECB’s current decision-making is based on the inflation outlook, underlying inflation dynamics, and policy transmission, we believe it will likely commence the rate-cutting cycle at one of its staff projection meetings – and the June meeting might constitute the first live meeting. Once the ECB does start to cut rates, we believe it will proceed cautiously in conventional 25-basis-point steps, unless the data suggest a solid undershoot of inflation in the medium term.

As for investment implications, current valuations leave us broadly neutral on European duration in the near term. Amidst elevated issuance needs, ending reinvestments weakens the relative technical picture for government bonds, and speaks to a continued rebuild of term premia over time. We expect the back end of interest rate curves to underperform relative to shorter maturities.

Interest rates: Wages hold the key

The GC wants to be further along the disinflation process before it is sufficiently confident that inflation will sustainably hit its target. This is why, instead of providing strong guidance beyond March, the GC continues to emphasize a data-dependent, meeting-by-meeting approach in an uncertain environment.

Although the new staff macroeconomic projections foresee headline inflation broadly at target in 2025 and 2026, there are concerns around persistent or “sticky” services inflation, on the back of still-elevated wage growth. The ECB’s March projections expect wage growth to be running at 4.5% year over year (yoy) in 2024, falling to 3.6% in 2025, and 3.0% in 2026. These numbers remain well above its long-run average of 2.1% and, for the time being, wages are growing solidly above any kind of equilibrium rate.

While wage growth in 4Q has weakened somewhat compared with the third quarter, it remains elevated. Moreover, several ECB experimental wage indicators point to continued strong wage growth, and the most important wage increases typically happen in the first quarter of the year. Despite the strongest tightening in the history of the euro area – 450 basis points in little more than a year – the unemployment rate sits at a historic 6.4% low, well below its pre-pandemic level and below estimates of the non-accelerating inflation rate of unemployment (NAIRU) for the euro area. (NAIRU is the theoretical unemployment rate at which inflation remains stable.)

Additional wage data in 2024 will therefore be crucial, as wage developments will largely determine the timing and scale of policy rate adjustment this year, though many countries will not release first quarter numbers until the end of April.

ECB balance sheet: waiting for the new framework to steer short-term rates

As we said in our January blog post, “ECB Firmly on Hold,” for both the asset purchase programme (APP) and the pandemic emergency purchase programme (PEPP), we do not anticipate the ECB to categorically rule out selling bond holdings, but we do envision a continued focus on a passive reduction of reinvestments. Indeed, unless the ECB is forced to aggressively cut policy rates towards zero, we think the bar for amending its reinvestment strategy is high.

Longer term, ECB reinvestment policy will potentially be influenced by the shape of the new operational framework for steering short-term interest rates. The ECB currently aims to conclude this review on 13 March.

Our baseline remains the same as in January, that the ECB will institutionalize the current excess liquidity framework, likely via a demand-driven corridor system where banks have unlimited access to a variety of collateralized liquidity operations. In addition, the ECB is likely to establish a permanent bond portfolio, which could replace the PEPP as the first line of transmission defense, essentially a transition towards a structural line of defense. Overall, we believe the market implications are likely to be limited near term.