For months, the ECB’s mantra has been that inflation and, therefore, monetary policy are in “a good place”. This has led the market and economists to expect no rate changes in the Eurozone this year. However, inflation is starting to move out of that good place, and it might be time to reevaluate the policy outlook. This could leave the Euro either weaker or strengthening depending on what happens with the upcoming data.
On Thursday, ECB President Christine Lagarde gave a presentation before the EU parliament, and largely stuck to the “good place” theme. But it was notable that there was a shift in emphasis and what the market focused on. Lagarde reiterated that she expected inflation to stabilise at the target in the medium-term, which is standard central bank rhetoric. The main takeaway was Lagarde’s comments on FX, in which she said the central bank was “monitoring” the currency rate. The EURUSD recently ticked above the 1.18 handle.
Inflation Falling Out of the Good Place
Earlier this week, Eurostat published the final reading of inflation for the shared economy and confirmed that the headline rate dipped to 1.7% from 2.0%. The main driver of the drop was lower energy and processed food prices, a trend that might continue in February after mild weather reduced natural gas and electricity costs in the region. The central bank will tolerate fluctuations in the headline inflation rate, as long as they are outliers.
But if inflation persists below target, the central bank might have to take action, such as lowering interest rates. If February CPI keeps falling, it could put pressure on the ECB to at least warn about consumer prices. Lagarde’s latest comments emphasised the wage growth pressure, which could be interpreted as mildly hawkish. That puts her a bit at odds with the latest figures, which are giving dovish hints, but there aren’t enough data points yet to establish a trend. That could change with February’s data.
Setting the Inflation Trend
Friday sees the release of flash February CPI from the two largest economies in the Eurozone, which could set expectations for the whole area’s data that comes out on Monday. In other words, the market could preemptively react to the data on Friday if it shows a trend to the upside or downside. If inflation is indicated as lower, the Euro could weaken as expectations mount that the ECB will address low inflation concerns. On the other hand, if CPI is hotter than anticipated, the central bank could stick to its good-place rhetoric and support the Euro.
There is a bias towards potential weakening because, with the ECB expressing concern over a strong Euro, it can achieve both its FX and inflation objectives by cutting rates. If inflation is hotter than expected, it would offset January’s data, and the ECB will be hesitant to signal hawkishness with EURUSD close to the 1.2000 handle. This means there could be more room for a downward move in the Euro than for an upside move.
What the Market is Looking For
French February flash CPI is first to come out, with the annual rate expected to return to 0.8% from January’s extraordinarily low 0.3%. Next up are the individual German states, which could give markets advance warning of whether the Eurozone’s largest economy is expected to be in line. This means the market reaction could consolidate right before the German flash February CPI is released. It’s expected to decline to 2.0% from 2.1% in February.
