The ECB meets tomorrow to change monetary policy. I expect a 50 bps rise and hawkish communication. The recent data, both on the core CPI inflation and activity side have surprised to the upside since December and support more hawkish communication about future hikes. While the 50bps hike is priced, I see a rising risk that the peak depo rate will be higher than priced in markets today.

 

In short, the ECB will look through Q4 German output weakness and instead focus on CPI inflation. I think we can expect the ECB to be super hawkish for the next couple of meetings.

 

In broader terms, the market is trading Spanish inflation broadly as a leading indicator for Euro Area HICP inflation. As mentioned last month, German and French HICP will rebound this month for mechanical reasons. However, the key for the ECB is persistence in core CPI inflation.

 

Normally, businesses pass-through higher energy costs over time. For oil, this indirect pass-through makes up 1/3 of the total energy price pass-through in the Euro Area. However, this pass-through occurs with a lag, so it is completely normal to see persistence of core CPI inflation after a large energy price shock. The issue is however, that it isn’t possible to tell these dynamics apart from second round effects.

 

I expect we will see core CPI persistence for the next couple of months which means that the ECB will remain very hawkish.

 

With respect to the German Growth data, yes that was weaker than expected, but I think that markets and the ECB will be much more focused on Q1 growth data given the much lower Gas prices since the beginning of the year. Here I continue to expect resilience.

 

The BoE will decide monetary policy and publish their forecasts tomorrow as well. Markets are only pricing a 45bps hike. This is because PMI data has begun to deteriorate, especially in the services sector and lower gas prices mean that the government will likely keep the energy price guarantee at £2500, rather than raising it again in April.

 

However, wages are rising way too fast in my view and there is a lot of labour market adjustment that still needs to happen. Markets are set for dovish hike, pricing a 10% chance of a 25bps hike. I think that the MPC will surprise markets on the hawkish side by raising 50bps and reiterating that they are ready to do more.

 

The BoE have been relying on a recession, caused by very high energy prices due to a large hit to incomes, to do the tightening work for them. Now with lower gas prices and shallower recession than anticipated in November, the Bank of England will likely have to do more of the work to cool UK wage inflation, which so far isn’t showing any signs of a slowdown in the actual data.

 

I think the BoE may try to send some very hawkish signals by showing that on current market interest rate projections, they could overshoot the target. Any information like this or just a change in language at the meeting will likely lead to a market selloff in Gilts.

 

Markets are also pricing a cut by the end of this year. Changes in the MPC this year may challenge this pricing. We had two votes for a flat bank rate at the last meeting. One of the voters for a flat bank rate in December will leave the MPC this year. The market is pricing this conditional on a dove replacing a dove.

 

However, there is a reasonably strong chance that they will be replaced by a hawk. The CBI's Chief Economist job was just advertised. Out of the previous 2 CBI chief economists, 2 became MPC members. It is therefore plausible, but of course speculative, that the current incumbent will join the MPC.

 

Those members with a CBI background on the MPC have historically been centrist or hawkish voters. After all, real economy firms don’t like it when their profits are being squeezed by rapidly rising wages. So again, given the likely slightly more hawkish MPC makeup towards year end, this pricing appears a bit premature.