Frankfurt: The European Central Bank kicks off a potentially heated two-day meeting on Wednesday, with officials to decide how their newly unveiled monetary strategy will affect short-term policy.
After raising their inflation target to 2% earlier this month and committing to be ‘aggressive or persistent’ to achieve it, the challenge for policymakers is to clarify what such an approach means for them. interest rates and the purchase of bonds. Disagreements immediately arose when draft potential wording was released, Bloomberg reported last week.
President Christine Lagarde stepped up the anticipation by promising “interesting variations and changes” to Thursday’s political announcement and her press conference. She also acknowledged that the unanimity she got when reviewing the strategy when it ended this month will be hard to replicate.
Forward-looking guidance, the language used by central banks to describe the future direction of policy, has become an important tool in times of uncertainty. The aim is to prevent unwanted market speculation which increases volatility and undermines the economy.
While investors don’t expect the ECB to immediately change interest rates or the two major asset purchase programs, they are looking to understand how the measures, their duration, and their intensity might change as they go. that the pandemic crisis ebbs.
The central bank, faced with rising inflation from the recovery that it says masks underlying weakness, must convince investors and the public that it will not tighten policy too soon and prevent recovery, nor will it leave price growth uncontrollable.
Interest rates – at record highs, with a deposit rate of -0.5% – have been confirmed in the Strategy Review as the ECB’s main tool, and guidance on them is closely linked to the progress of inflation. While it will certainly change to reflect the new target, some economists are looking for more specific persistence signals.
ABN Amro’s Nick Kounis expects the ECB to indicate that rates will stay at current levels or below for longer than investors currently expect. Markets are banking on the first 10 basis point increase for the end of 2023.
Jefferies’ Marchel Alexandrovich predicts a commitment that borrowing costs will not increase until 2023. “The ECB should not tolerate any ambiguity about what might happen to interest rates for the next 18-24 months,” a- he said in a report.
Recent comments from ECB executive board member Isabel Schnabel suggest that forecasts may be tied to real inflation rather than the central bank’s outlook, according to Gilles Moec of AXA Investment Managers.
Schnabel said in a speech last week that “a higher inflation outlook must be visibly reflected in the real dynamics of core inflation before justifying a more fundamental reassessment of the medium-term inflation outlook.”
This could be an important clue. She said this month that price growth may need to be “moderately” above target for a “temporary period” – less than a week before the Strategy Review is released with almost exactly the same language.
Asset purchase program
The ECB’s initial asset purchase program was overshadowed by the € 1.85 trillion ($ 2.2 trillion) pandemic emergency purchase program. Both use a similar strategy, however, by buying debt to keep borrowing costs low and ensure that the gap between returns in stronger and weaker economies – the spreads – doesn’t widen too much.
The guidelines on the APP are relatively vague, so if officials intend to signal that it will become a bigger stimulus vehicle after the crisis-related tools expire, there is plenty of room for change. .
The most likely option would be to transfer some of the flexibility of the pandemic program to the APP together with an extension of the ECB’s pledge to preserve favorable funding conditions, according to Luigi Speranza and his colleagues at BNP Paribas. This could involve a commitment to step up purchases under the old regime, currently 20 billion euros per month, “for at least a predefined period or until certain conditions are met”.
The ECB could also rethink the order in which it eventually intends to tighten its policy. NatWest Markets economists, including Giovanni Zanni, say raising interest rates while QE continues could be “sensitive and popular.”
“It could appeal to all levels,” they said. “There could be a trade-off between higher rates, desired by the north, and protection of spreads, desired by the south. “
Emergency purchasing in the event of a pandemic
The PEPP is explicitly temporary – tied to the current crisis – so there aren’t many ways to adjust medium-term directions. A simple way to signal more support would be to commit to using the full $ 1.85 trillion. For now, the ECB says that “the envelope does not need to be used in full”.
“Another important point could be to clarify the ECB’s definition of the end of the ‘coronavirus crisis’,” said Carsten Brzeski of ING. “Is the pandemic over when the eurozone has achieved collective immunity, or when the economy has reached its pre-crisis level or when the ECB’s own inflation projections have returned to their late level? 2019? “
The ECB’s policy statement commits to providing “abundant liquidity” to banks through regular and longer-term lending operations, and to reinvest the proceeds from maturing bonds. A more detailed, potentially time-bound commitment to some or all of these elements could also send a signal of continued political support.
One tool the ECB does not have at hand is the commitment to deliberately exceed its inflation target to make up for years of underperformance. Such guidance is built into the US Federal Reserve’s policy of targeting average inflation – a strategy that Lagarde and his colleagues have rejected.
“There are no new tools or a catch-up strategy similar to the Fed’s flexible average inflation targeting framework, so why should we expect the ECB to deliver inflation better on target? as part of the new strategy? ” said Nordea economists Anders Svendsen and Jan von Gerich. “A powerful and persistent forward orientation is the answer! “