By Dhara Ranasinghe

LONDON (Reuters – The record euro area inflation rate means that prices will be high at the European Central Bank’s policymakers meeting Thursday.

No immediate policy action is expected since the ECB in December laid out plans https://www.reuters.com/markets/rates-bonds/ecb-set-dial-back-stimulus-one-more-notch-2021-12-15 to wind up its 1.85 trillion euro ($2.09 trillion) pandemic stimulus scheme by end-March.

The price pressures continue to be strong, and the markets need information on whether or not the ECB is moving closer toward a more hawkish stance. The following five questions are important for the markets:

1. What will the ECB do about inflation?

Possibly. Possibly.

ECB chief economist Philip Lane said last week the ECB would tighten policy https://www.reuters.com/article/ecb-policy-lane/ecb-would-respond-if-inflation-stayed-above-expectations-lane-idUKKBN2JZ13A if inflation was seen holding above its 2% target, but such a scenario appears less likely for now.

Euro area inflation hit 5% in December, the highest on record https://www.reuters.com/world/europe/euro-zone-inflation-hits-5-marking-another-record-high-2022-01-07, and is forecast to drop back below target in the fourth quarter.

Officials think this projection is too optimistic. The January data released the day before the ECB meeting could give the hawks new ammunition for pushing for a change of tone. However, the minutes from the December meeting revealed deep divisions about inflation. GRAPHIC: When does the euro area inflation reach its peak? https://fingfx.thomsonreuters.com/gfx/mkt/myvmnjmkkpr/ECBFEB1.PNG

2. Is it possible for a Fed to be more hawkish and force the ECB into accelerating normalisation?

This is not likely. Lagarde believes that the ECB doesn’t need to be as aggressive as the U.S. central banks given the different economic circumstances. For one, the US labor markets are more tight than in Europe.

Katharine Neiss, chief European economist at PGIM Fixed Income said that “the euro area isn’t the U.S.A.”

“But, this is not a common cycle. So there needs to be a level of humility. And the ECB has to be awake to the potential for the recovery to be stronger than they thought.”

A flurry of U.S. rate hikes could complicate life https://www.reuters.com/business/nimble-fed-narrows-normalisation-window-timid-ecb-2022-01-27 for the ECB if the Fed completes its tightening cycle quicker than in the past, leaving the ECB with a shorter time to act. GRAPHIC: Benchmark bond yields are on the rise, https://fingfx.thomsonreuters.com/gfx/mkt/zdvxoaynapx/ECBFEB3.PNG

3. How does the ECB view market pricing in relation to rate increases?

Lagarde could push back against market rate hike bets that are not in line with the ECB’s loose monetary policy stance. Higher lending rates could cause problems for businesses if they lead to tighter financial conditions.

Markets are anticipating a rate hike of 10 basis points by October. Deutsche Bank (DE:) reckons https://www.reuters.com/article/ecb-rates-deutsche/ecb-to-hike-rates-by-25-basis-points-in-dec-22-deutsche-bank-idUKKBN2JY1TM the ECB will kick off with an aggressive 25 bps hike in December.

The ECB, however, has largely ruled out raising rates in the coming year. The ECB plans to slowly reduce its asset purchasing, but has no plans to do so immediately. They will not raise rates while it buys bonds. GRAPHIC: ECB on track to wind down PEPP by end-March, https://fingfx.thomsonreuters.com/gfx/mkt/movanymlwpa/ECBFeb2Capture.PNG

4. Is the ECB expecting second-round inflationary effects?

Policymakers will be watching for signs that higher wages and higher oil prices could lead to higher inflation.

The policymakers insist that they don’t see wage growth responding to inflation. Germany’s government believes the economic recovery and higher inflation will likely lead to https://www.reuters.com/article/germany-economy-idUSKBN2K00ZF “somewhat stronger wage growth” this year.

As we see tighter labour market conditions in Germany and other countries, the case for higher wages has never been stronger. But the question remains, “Will it be permanent?” said Piet Haines Christiansen, chief strategist, Danske Bank.

“Wages are missing pieces of the puzzle. If we see inflation, then we will have a rate increase.” That could be as early as spring next year. GRAPHIC: Are wage pressures expected to rise in 2022, or will they remain the same? https://fingfx.thomsonreuters.com/gfx/mkt/mopanymqlva/ECBFEB4.PNG

5. Is the macro picture affected by the changes in the response to the pandemic?

The Omicron coronavirus variant has weighed on the economy, but with most countries avoiding full lockdowns, data suggests activity is holding up relatively well https://www.reuters.com/world/europe/easing-supply-bottlenecks-give-german-business-glimmer-hope-2022-01-25.

Lane stated that the Omicron effect will not be measured over months but in weeks.

ECB monitors believe signs of an increase in economic momentum mean that pressure could mount to quickly remove stimulus. The outlook is also clouded by uncertainty, including high oil prices and the possibility of a slowdown in China. GRAPHIC: Euro zone PMI versus the COVID-19 case count, https://fingfx.thomsonreuters.com/gfx/mkt/akpezngoyvr/ECBFeb5.PNG