By Francesco Canepa
FRANKFURT – As guardians of stability in prices and financial markets, the last word central bankers want to be associated with is “panic”.
Yet that is precisely the term used by two top European Central Bank watchers to describe the message communicated by ECB President Christine Lagarde since she opened the door to a rate hike in 2022 to curb record-high inflation.
Investors took Lagarde’s words last week – which were unexpected, as she had earlier all but ruled out a rate hike this year – as a signal the ECB would tighten policy soon, sending borrowing costs soaring across the 19-country euro zone. Government bond yields have held onto their gains even though Lagarde later sought to clarify and soften her meaning.
“There can only be one conclusion: communication mission failed. This is ‘from patience to panic’,” ING’s economist Carsten Brzeski said on Twitter.
He drew a contrast with Lagarde’s predecessor Mario Draghi, who in 2012 famously quashed speculation about a break-up of the euro with just three words – “whatever it takes”.
“If you compare this to the Draghi era, it is extremely difficult for the market to know who to listen to,” Brzeski added in an interview.
Investors’ faith in a central bank’s communication is arguably its most valuable asset when it comes to managing market expectations, something all central bankers, including Draghi, have struggled with.
But a costly slip of the tongue at the onset of the coronavirus pandemic – when Lagarde said the ECB was not there to close bond spreads for struggling countries – has led to her facing increased market scrutiny.
Her challenge is compounded by the vagaries of a pandemic-era economy and her desire to maintain a public consensus among ECB policymakers.
Sources have told Reuters that a sizable minority of policymakers who take a hawkish stance on inflation wanted to start dialling back stimulus at Thursday’s meeting.
“Lagarde panicked, and shifted to the hawkish side to prevent a return to the Draghi-era of public disagreement (particularly in Germany),” UniCredit’s chief economics advisor Erik F. Nielsen said in a research note.
He added in an interview: “If the institution is led by a President swaying between sides it is difficult to give a consistent message.”
After Lagarde’s news conference on Thursday, investors brought forward their expectations for when the ECB will end its bond-buying programme and raise interest rates for the first time since July 2011.
Analysts expect the former to happen well before year-end and money markets have priced in the ECB’s deposit rate climbing all the way back to zero by December, from -0.5% currently.
This is the widest disconnect between market expectations and the ECB’s official guidance, which is for rates to stay at their present record-low level or even be cut, since the guidance was introduced in 2013.
The rapid shift in expectations led another ECB watcher, Pictet economist Frederik Ducrozet, to ask on Twitter if Lagarde would be forced to give a remedial interview, as she did in March 2020 after her remarks had unsettled bond markets.
On Monday, Lagarde told the European Parliament there was no sign that a “measurable tightening” of policy was needed – a speech described by Paul Donovan, chief economist of UBS Global Wealth Management, as “accompanied by loud splashing sounds as policy was inexpertly rowed backwards”.
But Lagarde’s messaging has so far failed to soothe market nerves, a problem particularly for Italy and Greece, which have relied on the ECB’s bond purchases to keep their financing costs in check throughout the coronavirus pandemic.
Yields on 10-year Italian government bonds have jumped from 1.4% to 1.8% in a matter of days and on their Greek counterparts from 1.8% to 2.5%, while risk premiums for the countries’ debt compared to ultra-safe Germany’s have widened.
Lagarde’s reassurances that the ECB has plenty of tools to keep spreads under control, including reinvesting proceeds from maturing bonds bought as part of its quantitative easing (QE) programme, has not reassured investors either.
“The spreads widened dramatically because if we don’t have QE, what are the tools?” UniCredit’s Nielsen said. “We only have investments but whether that’s enough, no-one seems to believe it.”
Even former ECB vice-president Vitor Constancio made a rare criticism of its hawkish shift following two record inflation readings, comparing its policy setting to “looking out the window” – a citation from U.S. economist Alan Blinder.
“Central banks must be forward-looking and therefore must use models and projections, adding, of course, some judgement,” Constancio tweeted.
“Looking out the window, seeing the temperature, and deciding, is a very bad strategy for monetary policy.”
(Editing by Catherine Evans)