The culmination of the European Central Bank’s strategic review was that the inflation target would be increased. During an era of persistently low inflation, this begs the question, will the ECB ever manage to get out of its stimulus spiral. “QE forever” is the jibe. The wording of the new monetary policy statement released today leaves the ECB wide open to this accusation.
- ECB reconfirms its existing monetary policy stance.
- Forward guidance changes mean the hurdle for inflation to overcome for generating interest rate hikes just got higher.
- Market impact shows choppy markets but EUR moving higher. We do not expect this to last.
ECB reconfirms rates and asset purchases
There were zero surprises in the monetary policy decisions:
- Interest rates were held steady. The main refinancing rate is zero and the deposit rate is -0.50%
- The Pandemic Emergency Purchases Programme (PEPP) will continue at a “significantly higher pace” over the current quarter. The total envelope of €1,850bn will run at least until the end of March 2022, or when the Governing Council deems the pandemic to be over.
- The Asset Purchase Programme (APP, the long term ongoing QE programme) will continue at €20bn per month.
- Targeted Long Term Refinancing Operation (TLTRO, generating liquidity for the banking sector) will continue.
Inflation target has become extremely hard to achieve
There are three factors for inflation targeting 2% now.
- The inflation projection of 2% needs to be “well ahead” of the end of the projection. Lagarde confirmed in the press conference that this meant the mid-point of the projection. That would currently be by 2022. Clearly, we are not there yet.
- Also inflation projection needs to be “durably for the rest of the horizon”. This would suggest sustainably around 2%.
- “realised progress in underlying inflation” that is consistent
Here is the relevant section in the monetary policy statement:
The ECB is also able to accept a “transitory period” where inflation is moderately above target. Wow! These are big hurdles that inflation needs to overcome for the ECB to tighten interest rates. This is the current set of staff projections:
We can see no sign of 2% for inflation anywhere before 2024. The expectation is that as the pandemic subsides, inflation will begin to trend lower again, moderating towards 1.5% and 1.4%. Inflation being “durably” at 2% “well ahead” of the end of the projection horizon could take years!
Economic conditions change over time. However, even with a once in a lifetime economic shock that the pandemic is, the Eurozone is not even expected to generate inflation of 2%. It is increasingly difficult to see how inflation can increase to 2%.
That would suggest the ECB will not be able to increase rates for many years to come. In her press conference ECB President Lagarde said, “None of us would like to tighten prematurely”. There is little chance of this happening.
Attention will turn to what happens to PEPP
It is still too early for any confirmation from the ECB, however, markets will begin to look towards what the ECB does with its PEPP programme in the coming months.
We can expect an update on the “significantly higher pace” of PEPP purchases in the next meeting. Given the increase in the delta variant of COVID-19, it seems likely that PEPP purchases will continue to be conducted at increased rates. This would be risk positive (positive for DAX) but also negative for EUR on an ongoing basis.
Looking further out, inflation is not happening and the ECB needs to step up its efforts to get inflation back towards the target of 2%. This would suggest that PEPP purchases of their current format may well end in March 2022 (pandemic depending). However, the loss of monthly PEPP purchases is likely to be countered by an increase in the APP purchases.
Markets have been choppy since the ECB announced its policy stance at 1145GMT. WHat the ECB has announced has been all very dovish. However, there has been little new that the market has learned that it did not before. Markets seem uncertain.
It is interesting to see that after the initial minutes of volatility, EUR fell, however, it has since regained lost ground to trade slightly higher. However, we do not expect this move to continue.
This has also been seen in bund yields but to a lesser extent. The two tend to be fairly well correlated in the wake of ECB announcements and this lack of movement higher on the Bund yield suggests the EUR/USD move may not last.
The ECB has confirmed a very dovish stance that leaves it very difficult to see when any hikes to interest rates will be seen. It also confirms the ECB as being one of the most dovish central banks of the major currencies.