Central Bank Extravaganza

ECB Preview: Flexibility and optionality the name of the game for asset purchases

The ECB meets later this week, with the future of its asset purchase programmes on the table. In addition, its updated forecasts for inflation, including an extension of its horizon to 2024 should give guidance on the outlook for policy rates. Meanwhile, the new Omicron strain has added more uncertainty to the mix. Below we set out what we expect on these key topics.

The end of PEPP

We remain of the view that the ECB will wind down its net asset purchases under the PEPP by March of next year, despite the eurozone’s continued struggles in containing Delta and the emergence of Omicron. Even if Omicron leads to new global restrictions for a longer period, it is unclear at this stage what that would mean for the medium term outlook for inflation. The ECB reduced its medium term forecasts for inflation when the pandemic first broke, but over recent quarters it has been raising them and we are currently back in line with its pre-Covid outlook. This reflects that the demand shock has been slowly overtaken by a supply shock. There is a possibility that the ECB may delay a decision on the PEPP until early next year, but given the above considerations we think the central bank will push on and signal that the programme will likely end in March as planned. It could however maintain some optionality, by stressing that this scenario is dependent on developments, which it is monitoring carefully. In addition, PEPP can always be re-introduced at any stage if needed. PEPP will also continue via reinvestments and it could also decide to redistribute these flexibly, based on market circumstances.

A more flexible APP

The end of PEPP will not be the end of net asset purchases. It is clear that the APP will continue at least through 2022. Much of the debate on the APP has centred on the idea that the ECB will increased the fixed monthly amount (currently EUR 20bn) in order to smooth the transition from the PEPP wind down. However, in our view it makes much more sense to replace the fixed monthly amount with a sizeable APP envelope, which can be distributed flexibly in the coming months. The ECB sets policy to achieve a level of overall financial conditions that is appropriate given the inflation outlook. An APP envelope would allow the ECB to spend big if market conditions require it, and hardly at all, if financial conditions remain easy. Inflation outlook could signal long period of unchanged rates - We expect the ECB to signal a gradual build-up of underlying inflationary pressures over 2023-2024 (see below). However, its projections will still likely imply a long period of unchanged policy rates. We think the ECB’s projections will show inflation slightly below the 2% target in 2024. Given that the ECB will not hike rates until it sees inflation sustainably achieving the 2% level within 12-18 months, the new forecast should signal policy rates on hold at least for most of 2023 and possibly even until 2024. This would obviously point to a big and growing policy divergence with the Fed and the BoE.

ECB to revise inflation projections higher

When forecasting growth and inflation the central bank uses a set of technical assumptions for bond yields, the trade-weighted exchange rate of the euro and oil and other commodity prices. Since the ECB’s previous projections (September), bond yields and oil and other commodity prices have risen, but the trade-weighted euro exchange rate has declined. These changes will have an opposite impact on future GDP growth, which, on balance, will probably be slightly lower. However, with regards to the outlook for inflation, they will each work mostly in the same direction and raise inflation. Combined with the impact of Omicron, the ECB will probably lower its GDP growth forecast for 2022 (currently at 4.6%) somewhat, while raising its forecast for 2023 (currently at 2.1%). The first estimate for 2024 will probably be close to the trend rate of around 1.6%. The changes in the technical assumptions, as well as the potential impact of Omicron on supply bottlenecks, will have an upward impact on inflation. We expect the ECB’s forecast for inflation in 2022 to rise to around 2.2-2.3% (up from its current forecast of 1.7%). Considering that there will probably be some delayed second round effects from the rise in inflation in 2021-2022 on (core) inflation in 2023-2024, and taking into account that GDP growth is expected to remain above the trend rate on average in 2022 and 2023, we expect the ECB’s estimate for inflation in 2023 to be revised higher to around 1.7% (from 1.5% now). The first estimate for inflation in 2024 will probably be around 1.9%. (Nick Kounis & Aline Schuiling)

FOMC Preview: Quicker taper, and a steeper rates path

At the outcome of the December policy meeting this Wednesday, the Fed is widely expected to announce a speeding up of its tapering of asset purchases. We and most of those surveyed by Bloomberg expect a doubling in the monthly taper pace, with asset purchases set to drop by $30bn per month from January rather than the current $15bn, and with asset purchases expected to end in March rather than June (as would be the case if the taper pace were kept unchanged). Alongside this, the Fed will also come with a new set of projections, which is likely to contain upgrades to inflation forecasts, as well as to the projected path of the fed funds rate. As of September, the Committee expected one rate hike in 2022, and roughly three further hikes in both 2023 and 2024. The near term path for rates is likely to be steeper in the December projections; our own expectation is for three rate hikes each in 2022 and 2023. The Bloomberg survey meanwhile shows most respondents expecting the Committee to project two hikes in 2022 and three in 2023, and another two in 2024.

A hawkish Powell might seek a modest tightening in financial conditions

Given recent inflation developments and the significant hawkish pivot Chair Powell and many FOMC members have made recently, we would view the Bloomberg survey expectation as a minimum in terms of the shift in rate projections, i.e. the risk is that markets are surprised by something more hawkish than this. In the press conference, we expect Chair Powell to elaborate on how the Fed’s thinking around inflation has shifted over the past two months, and given how accommodative financial conditions have remained – with equity markets back near all-time highs, and Treasury yields subdued – we think Powell will likely feel more at ease making hawkish remarks about the Fed’s willingness to respond aggressively in order to tame inflation if necessary. Indeed, with broader financial conditions a key early transmission channel for changes in monetary policy, Powell might even seek actively to engineer a modest tightening in conditions as a precursor to actual rate hikes in the months ahead. (Bill Diviney)