Global Daily – The ECB’s Financial Conditions Control Framework
There were no new policy announcements in the Governing Council’s January monetary policy press release. However, it did give some further guidance on the outlook for the PEPP purchases. It noted that ‘the purchases under the PEPP will be conducted to preserve favourable financing conditions over the pandemic period. If favourable financing conditions can be maintained with asset purchase flows that do not exhaust the envelope over the net purchase horizon of the PEPP, the envelope need not be used in full. Equally, the envelope can be recalibrated if required to maintain favourable financing conditions to help counter the negative pandemic shock to the path of inflation’.
In the press conference following the decision, ECB President Christine Lagard explained this framework in more detail. There were a number of key points to note:
(1) the ECB has shifted from targeting a specific volume of net asset purchases to wanting to maintain favourable financing conditions
(2) how favourable financing conditions need to be depends on the inflation outlook – the ECB wants financing conditions in the economy that are consistent with inflation moving back towards its objective
(3) financing conditions are defined broadly – it referred to all sectors of the economy (companies, households and governments) and hence related to multiple variables
(4) Having said this, the ECB head did admit that ‘government bond yields play an important benchmark role for the pricing of credit’ and indeed in our view it is noteworthy that the PEPP has been focused almost exclusively on public sector purchases. As such, although the PEPP has a broader framework than explicit yield curve control, the importance of yields in it means that it resembles a more implicit and flexible form of yield curve control.
(5) The ECB seems content with current financing conditions and Ms. Lagarde noted that ‘at the moment there are no yield developments that pose an issue for euro area wide financing conditions’. Indeed, we observe that the GDP-weighted average eurozone bond yield has been moving in a narrow range over the last few months.
What does all this tell us about the ECB’s reaction function? The ECB seems content with the its current pace of purchases given that it thinks it is achieving the financing conditions consistent with its current inflation outlook. This could change. For instance, if the inflation outlook deteriorated, easier financing conditions would be necessary and it may need to step up net purchases in an effort to drive down yields and spreads further. Indeed, Ms. Lagarde emphasised that underlying inflationary pressures remained subdued and the risks to the outlook were to the downside, albeit less pronounced than previously. Of course the same holds in reverse: positive growth and inflation surprises could mean less easy financing conditions were appropriate.
Another trigger for the ECB could be a tightening of financing conditions from current levels, with the inflation outlook unchanged. For instance, a rise in core yields triggered by supply or country/credit spreads due to a deterioration in investor appetite. In this case, we would expect the ECB to step up net purchases to restore financing conditions.
We are currently projecting that the ECB will need to use the full PEPP envelope and sustain APP purchases after the PEPP retires. This is because even on ECB projections, the central bank will miss its inflation goal by some margin. At the same time, given the spare capacity in the economy, the ECB’s projections for inflation even look optimistic. Meanwhile, the ECB will likely need to sustain purchases to mop up enormous public sector supply.