Market participants were quick to detect a “hawkish pivot” in the European Central Bank’s subtle word changes at its press conference last week. ECB president Christine Lagarde declined to repeat her earlier judgment that an interest rate rise this year was “highly unlikely”. Instead she reported “unanimous concern” among the euro’s monetary policymakers over the latest inflation number, which at 5.1 per cent was higher than they had expected.
It was enough to send euro bond markets into a minor tailspin, with a jump in yields that was particularly large in economies with the most debt-laden governments.
Taking the changed language as a signal to sell was understandable. Many economic observers take their cue from the increasingly hawkish rhetoric and action of the Federal Reserve and the Bank of England. If those central banks are behind the curve, so, they conclude, is the ECB. Market pricing suggests eurozone policy rates could go up as soon as June.
That analysis, however, ignores another part of Lagarde’s message: that the eurozone differs in important ways from both the US and the UK. She is right — and markets would be wise to heed it.
Above all, continental Europe has been much more successful in bringing people back into work — probably in large part thanks to the bloc’s better-established furlough schemes — than the US and the UK, where the number of jobs still lags pre-pandemic trends. In aggregate, the monetary union now has more people in work than before the pandemic, and unemployment is the lowest since the euro’s creation. (Nevertheless, there are worrying differences between euro countries — notably, Germany lags behind its peers in recovering pre-pandemic employment rates.)
As a result of this lack of labour market scarring, the euro’s interest rate setters see little sign of wage pressures. If anything, Lagarde suggested she would welcome somewhat faster wage growth: “I am not here saying that there should be wage moderation”, she said last Thursday, in sharp contrast with the Bank of England governor’s warning against strengthening wage demands on the same day.
That is not the only way the euro area distinguishes itself from economies across the Channel or the Atlantic. The eurozone has not seen anything like America’s enormous shift in consumer spending towards manufactured goods away from services. And while shortages of workers are felt everywhere, the continent does not have to contend with the additional negative labour supply shock the UK has inflicted on itself through Brexit — another point mentioned by Lagarde.
It no doubt serves the ECB that markets do some of its work for it: the recent sell-off in effect brings forward some of the tightening that will eventually come. In remarks to the European Parliament this week, however, Lagarde hinted markets may have got carried away.
The paradox is that since its strategy review last year, the ECB has had in place a commendably clear — if intricate — set of criteria for when it will tighten. Medium- and long-term inflation expectations very close to the ECB’s target testify to the new framework’s effectiveness.
In the short term, however, markets are driven by their second-guessing of how the euro’s central bankers will react to the discomfort of prolonged above-target inflation. Bringing even more focus to the ECB’s criteria could help both markets and central bankers keep their heads cool.