Don't have too high expectations for interest rate cuts? The ECB's hawks are back!

As the market bets that the European Central Bank (ECB) will continue its easing policy, Executive Board member Isabel Schnabel recently sent strong hawkish signals in a speech, attracting the attention of investors.

In a significant speech on May 9, ECB Executive Board member Schnabel expressed a clear hawkish view, stating that the ECB should "maintain interest rates close to current levels—firmly within the neutral range." The reasoning is that fiscal expansion and tariffs in the eurozone may push potential inflation higher in the medium term.

According to Wind Trading Desk, JP Morgan analyst Greg Fuzesi pointed out in a research report titled "ECB: Schnabel is back, delivering an important hawkish speech" on May 12 that although Schnabel's stance is hawkish, overemphasis on hawkish interpretation underestimates the downside risks of inflation.

JP Morgan believes that most ECB policymakers may not follow her view, expecting the terminal rate to reach 1.5%, as other central bank officials are more concerned about economic growth and downside risks to inflation.

Schnabel's Hawkish Stance Fully Returns

The research report states that Schnabel clearly indicated in her speech that given the resilience of economic growth and the potential for trade wars to increase inflationary pressures, the ECB should "maintain its resolve." The core logic of this conclusion lies in her assessment of the slope of the Phillips curve and the impact of current tariff shocks. Schnabel emphasized two main factors in her speech:

First, eurozone fiscal policy is "expanding at an unprecedented scale," and this "fiscal impulse may pose upward pressure on potential inflation in the medium term";

Second, trade policy shocks may also push up medium-term inflation, partly because economic growth may remain resilient.

Schnabel believes that external demand in the eurozone may remain resilient, partly because the eurozone focuses on producing goods that the U.S. needs and cannot easily substitute, meaning that eurozone exports have low price elasticity. She cited research indicating that the eurozone may thus benefit relatively in the global trade war. At the same time, a stronger euro would reduce the costs for eurozone companies importing intermediate goods.

In this context, she believes that the recent improvement in the eurozone manufacturing PMI, particularly the new export orders index, provides some validation for this view. However, she is concerned that potential disruptions in the supply chain and larger-scale retaliation from the EU could impose cost shocks on eurozone companies. Due to resilient external demand and low price elasticity of their products, companies may pass these costs onto consumers. JP Morgan pointed out,

What worries Schnabel even more is that after experiencing recent high inflation, inflation expectations may still be fragile, and any new inflationary pressures could lead to a de-anchoring, especially for short-term inflation expectations that have a greater impact on macroeconomic outcomes.

Based on the above, JP Morgan states that Schnabel believes medium-term inflation risks are tilted to the upside, and her policy conclusion is naturally hawkish; she even seemed to need to persuade herself not to call for interest rate hikes during her speech. This contrasts with the view of ECB Vice President de Guindos a few days earlier, who believed that growth and inflation risks are tilted to the downside and suggested that economic uncertainty could lead to wage growth slowing more than expected

JP Morgan: Cautiously Assessing Hawkish Views

Fuzesi believes there is significant uncertainty regarding how trade policy shocks will evolve, and Schnabel's analysis significantly leans towards a hawkish interpretation and judgment. Fuzesi provided the following examples in the research report:

1. Limitations of Low Price Elasticity: Schnabel uses two companies that produce highly specialized machinery and are almost the only manufacturers globally as examples to illustrate low price elasticity. However, JP Morgan points out that many other Eurozone companies produce goods with higher price sensitivity.

2. Doubts About the Implementation of Fiscal Policy: Her views on fiscal policy seem to be ahead of the current willingness and capability of governments.

3. Underestimating Downside Risks: She does not elaborate much on potential downside risks, for instance, she mentions that "as long as tariffs do not prohibit trade and the uncertainty paralyzing economic activity diminishes," external demand may remain.

Additionally, Schnabel hopes that trade negotiations can reach a "mutually beneficial agreement." JP Morgan believes that while these situations may occur, they are far from certain, and the role of monetary policy in providing support in the short term may be greater