Our market analysts have been saying for some time that the ECB was underestimating the persistence of excess inflation, and last week's hawkish message proved just that. Click here to read our ECB reaction report.

Matthew Ryan, our Senior Market Analyst, commented:

“We have been saying for some time that the ECB was underestimating the persistence of the inflation overshoot in the Euro Area, and last week’s message goes a long way in acknowledging that. We have also been quite contrarian in our view that we would soon see a growing chorus of hawkish dissent among Governing Council members, having said for the first time in early-December that higher interest rates in the Eurozone couldn't wait until 2023.

Lagarde’s communications on Thursday fully validate our view. The ECB voiced heightened concerns over the inflation overshoot, and Lagarde did not repeat her line that interest rate increases were unlikely in 2022 when directly asked. We now think that the ECB will recalibrate its asset purchase programme in March, and raise interest rates no later than the September meeting, possibly earlier. Markets have finally come around to this view, and are now pricing in around 50 basis points of hikes in the ECB's deposit rate by year-end.”

Get to know our market analysts and hear their thoughts on last week’s ECB announcement and the key indicators to look out for when forecasting currencies.

Enrique Diaz Alvarez, Roman Ziruk, Matthew Ryan, and Itsaso Apezteguia

1. What made you think that the ECB, and the market, was underestimating the persistence of excess inflation in the Euro Area?

We think that the market, and perhaps the ECB itself, has taken a rather short-term view on inflation, extrapolating the post-Great Financial Crisis experience with inflation into the far future. We have attempted to take a more long-term view. Not since WWII has there been a historical episode of a culmination of acute supply shortages, soaring energy prices and an unleashing in massive pent-up demand to the extent we have seen during the current pandemic. All the while, fiscal and monetary policies remain at enormously stimulative levels worldwide.

Price developments in the US also tend to be a leading indicator of inflationary pressures in Europe, as has turned out to be the case in the past few months. ECB President Lagarde has recently stated that Europe is unlikely to experience the same price pressures as the US. We see this as a miscalculation. The main drivers of rising prices, higher energy costs and ultra loose fiscal and monetary policies are worldwide phenomena, not limited to the US.

2. What do you expect from the March ECB meeting? How will the euro be affected?

In our view, the March Governing Council meeting will arguably be the most important since the early stages of the pandemic. Lagarde made it clear last week that ECB members are becoming increasingly concerned with rising inflation, while backtracking on claims that the market was overestimating the chances of rate hikes in 2022. We believe that policymakers are finally coming around to the view that maintaining such an extraordinary accommodative policy stance, particularly by historical standards, in a highly inflationary environment is unsustainable.

We expect the ECB to announce a hawkish recalibration of its asset purchase programme in March, which would pave the way for interest rate hikes before the end of the year - we think no later than September, possibly earlier. The euro will remain well supported as markets continue to adapt to the ECB’s turnabout on policy.

3. What data/indicators do you usually look at when you create your forecast reports? Which sources do you rely on?

In the current environment, the most important macroeconomic indicators for investors are those on inflation. Rising inflation, which is now well above central bank targets in most instances, has become the key cause for concern for ratesetters, particularly given the waning impact of the pandemic on economic activity. In forming our analysis, we now give extra scrutiny to both headline and core inflation prints, and the various underlying drivers of price pressures, notably commodity and energy costs, as well as the extent to which these pressures are filtering through to wages.

Aside from the traditional CPI data, we also pay close attention to the business activity PMIs, particularly of late the prices subindicies. We also closely watch real interest rates, denoting the difference between short-term bond yields and inflation expectations. The difference between real rates, and market expectations for changes in central bank interest rates, is one of the key drivers of currencies in the short- and medium-term. We track all of the above on economic calendars, that from FXstreet is a preferred one of ours, and analyse historical data on tradingeconomics, as well as the Bloomberg and Refinitiv platforms.

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