Global Daily – ECB could be on hold through 2024

Policy rates – The new guidance on interest rates states that the Governing Council ‘expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. This may also imply a transitory period in which inflation is moderately above target’.

In the press conference, ECB President Christine Lagarde clarified that ‘well ahead of the end of its projection horizon’ referred to the ‘midpoint’ of the 2-3 year horizon, though the Governing Council has some discretion on this point. Meanwhile, the decision on the new guidance was not unanimous, but on the basis of an ‘overwhelming majority’.

The previous guidance stated that  the Governing Council ‘expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics’.

So the key differences are (a) as we know already, the inflation goal it needs to reach is now higher (b) It will keep policy accommodative until inflation hits the target during its projection horizon rather than at the end of it (c) it is willing to accept a temporary overshoot in this process.

The ECB’s Staff currently projects that inflation will reach just 1.5% by the very end of its horizon, which runs until 2023. In addition, the trajectory of inflation is very modestly upward sloping (at roughly 0.1 percentage point per year). For the purposes of illustration, assuming that trend continues, it would probably be 2025 before the ECB sees inflation at around target levels well before the end of its forecast horizon. This would be consistent with policy rates remaining where they are through 2024.

APP purchases – APP would also continue for much of this period, given its guidance that it ‘continues to expect monthly net asset purchases under the APP to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates’.

PEPP purchases – Meanwhile, there was no change in the guidance on the PEPP. It notes that the ‘Governing Council continues to expect purchases under the PEPP over the current quarter to be conducted at a significantly higher pace than during the first months of the year’. In addition, it expects net purchases under the PEPP to continue ‘until at least the end of March 2022 and, in any case, until it judges that the coronavirus crisis phase is over’. The exact definition of the ‘coronavirus crisis phase’ is unclear. Some officials have signalled that the level of GDP would need to be back to its pre-corona level, which we (and the ECB) expect to be the case around March of next year. Although rising new virus cases have raised some downside risks to the economy, we stick to our base case.

Macro outlook – This seems to be also the ECB’s view of the outlook right now. Indeed, it stuck to its view that risks to the economic outlook are ‘broadly balanced’. It explains that ‘economic activity could outperform our expectations if consumers spend more than currently expected and draw more rapidly on the savings they have built up during the pandemic. A faster improvement in the pandemic situation could also lead to a stronger expansion than currently envisaged. But growth could underperform our expectations if the pandemic intensifies or if supply shortages turn out to be more persistent and hold back production’.

Policy going forward – In our view, the implication of this new guidance is consistent with a much more prolonged period of policy accommodation than currently priced in by financial markets. Policy rates could remain on hold through 2024, while the APP would also continue for much of that period. Our base case is that the PEPP will end in March of next year. At that point, the purchase pace of net purchases under the APP will likely be increased. The announcement of a wind down of the PEPP and a higher APP purchase pace will probably be communicated at the same time. That seems likely at the December Governing Council meeting. (Nick Kounis & Aline Schuiling)

Please note that due to the holiday period, the Global Daily Insight will also take a break. Key events in the meantime will be covered in our other publications.