Global Daily – ECB still focused on easy financial conditions

The message from Vice President Luis de Guindos was similar. He said that the ECB should ‘maintain very accommodative monetary policy conditions’.

Governor of the Banque de France Francois Villeroy noted that ‘there’s no risk of a return of lasting inflation in the euro area, and so there’s no doubt that the ECB’s monetary policy will remain very accommodative for a long time. I want to say that very clearly’. Chief Economist Philip Lane also dismissed inflation fears, saying that ‘the idea that the world and the euro area has a kind of environment that is set up for persistent inflation – I just don’t see it’. In terms of the inflation outlook, he added that the ECB ‘had a lot of work to do’. Finally, Governor of the central bank of Greece Yannis Stournaras came out in support of sustaining the recent higher pace of net purchases next quarter, asserting that he saw ‘no reason to make any change’.

The recent commentary from ECB officials makes sense given recent developments. First of all, the eurozone sovereign curve has steepened considerably. The 10y eurozone weighted rate has risen significantly over the last few months and currently sits at around +0.25%, compared to roughly -0.25% in mid-December. The 50bp rise in yields would not necessarily be a bad thing if the inflation outlook had improved significantly. However, that does not seem to be the case. Although headline inflation has accelerated over recent months, core inflation remains extremely subdued. Undoubtedly, the economy has turned a corner and rapid economic growth is on the cards in the coming months.  Though it is important to note that the ECB has largely factored this outlook already in their base line scenario, and even with rapid economic growth, spare capacity will likely remain over the medium term.

So it looks as if the ECB will likely announce in June that net purchases under the PEPP will be sustained at the recent level in Q3. Such an announcement in itself may not have a huge market impact. First, it has already been partially priced in. Second, the size of the additional purchases (in terms of the step up relative to earlier this year) is moderate. Third, the ECB could well also announce in June that the risks to the economic outlook are now ‘balanced’ rather than to the downside. Although the ECB is still likely to project that inflation will undershoot its goal over the medium term  – and it is inflation rather than growth that matters – this could still be seen as a hawkish signal by investors. As such, sustaining PEPP purchases might not be enough to convince investors of the ECB’s dovish intentions.

This raises the question of what else the ECB could do. In our view, the key driver of the rise in long rates has been the pricing in of policy rate hikes over the coming years. The ECB could push back against these expectations by strengthening its forward guidance. This can be done by signalling much more explicitly that policy rates will remain on hold for a much longer period than markets expect. Alternatively, it could send the same message indirectly by signalling a much longer period of net purchases under the APP beyond (and perhaps with more flexibility and volume than currently) when the PEPP ends in March 2022. Finally, the ECB still has the option to cut the deposit rate further, though this would likely not be the first port of call.