Hesitant ECB will probably step up bond purchases - Capital Economics
European Economics

Hesitant ECB will probably step up bond purchases

ECB Watch
Written by Andrew Kenningham

At next Thursday’s monetary policy meeting we expect the ECB to nudge up its forecast for inflation in 2021 and nudge down its forecast for GDP growth, but stress that inflation is still likely to fall short of the near-2% target over the medium term. With no prospect of any change to its policy settings, the focus will be on the Bank’s efforts to explain how and when it would step up bond purchases in response to rising bond yields. On balance, we think the upshot will be higher purchases and slightly lower yields in the coming weeks.

  • Policymakers will stress that inflation likely to be below target in medium term.
  • Christine Lagarde may make another effort to clarify the ECB’s “reaction function”.
  • We suspect the Bank will ultimately step up PEPP purchases a bit in coming weeks.

At next Thursday’s monetary policy meeting we expect the ECB to nudge up its forecast for inflation in 2021 and nudge down its forecast for GDP growth, but stress that inflation is still likely to fall short of the near-2% target over the medium term. With no prospect of any change to its policy settings, the focus will be on the Bank’s efforts to explain how and when it would step up bond purchases in response to rising bond yields. On balance, we think the upshot will be higher purchases and slightly lower yields in the coming weeks.

ECB to revise up its inflation forecasts…

The main point of interest in the revised economic projections to be published next week will be the higher inflation forecast for 2021. The previous forecast, released in December, was for inflation to average 1.0% this year, but headline inflation rose to 0.9% in January and February and energy price inflation is set to increase a lot further in the coming months. The ECB will have to raise its assumption about oil prices from the $45pb which they assumed for this year and next in December.

Table 1: Macroeconomic Projections

2021

2022

2023

GDP (% y/y)

– ECB (Dec.)

3.9

4.2

2.1

– Consensus

4.3

4.0

1.8

– Capital Econ.

4.0

4.0

1.5

HICP (% y/y)

– ECB (Dec.)

1.0

1.1

1.4

– Consensus

1.1

1.2

1.5

– Capital Econ.

2.0

1.0

1.0

Sources: ECB, Consensus Economics, Capital Economics

Our best guess is that the ECB will raise its inflation forecast to around 1.5%, which is a little lower than our expectation that it will reach 2.0%. (See Table 1.)

Crucially, though, we do not expect the Bank to change its view that inflation will be well below the near-2% target beyond next year. Even Bundesbank President Jens Weidmann acknowledged this week that Germany’s inflation rate is likely to increase only temporarily. And Fabio Panetta said the ECB should look through a “temporary hump” in inflation driven by “statistical effects linked to the composition of the consumption basket, as well as base effects…and the unwinding of the VAT cut in Germany.”

…and revise down its GDP forecasts

The Bank is also likely to sound a more cautious note about the outlook for growth. Since January, business surveys suggest that the manufacturing sector has continued to thrive, but the services sector PMIs have been very low and retail sales fell by 5.9% m/m in January. With new virus cases rising, lockdowns have been extended in some countries and are likely to be tightened in others. The slow vaccination rollout means the best of the post-lockdown bounce in the economy may be pushed back from Q2 to Q3. (See here.) All in all, we think the Bank is likely to nudge down its GDP growth forecast marginally but leave it unchanged for 2022.

Harder, better, faster, stronger

Of more interest next week is how the ECB will explain its response (or lack of it) to the recent rise in bond yields. Over the last three weeks, nominal yields, the Italy-Germany spread and real yields have all risen. (See Chart 1.) This has revealed the lack of clarity and speed over how the ECB decides whether to use the much-vaunted flexibility in the PEPP.

In principle, the Governing Council has delegated to the Executive Board “the power to set the pace and composition of monthly PEPP purchases within the total overall envelope”. (See here.) But while most members expressed concern about the rise in yields, the Executive Board appears to have made no decisions over the past two weeks.

Chart 1: 10-Year Bond Yields (%)

Sources: Refinitiv, Capital Economics

Indeed, as Chart 2 shows, the Bank actually reduced its PEPP purchases last week. So for now, the Bank’s revealed preference is to allow bond yields to be buffeted significantly by changing global conditions.

Chart 2: Weekly PEPP Purchases (€bn)

Sources: Refinitiv, Capital Economics

This failure to act in part reflects the inherent ambiguity of its policy of implicit yield curve control. As Table 2 shows, policymakers have focused on different measures when assessing the current situation: nominal and real yields; the spread between peripheral and core bonds; and wider financing conditions. Without an explicit yield target, there is no known threshold which would trigger a policy response. The moves so far have not been huge, as Chart 1 also shows, so some policymakers will probably have argued that they do not justify any response from the ECB.

This episode has also highlighted differences of opinion about how the ECB’s policy framework should work. In his “Daft Punk” speech this week, Fabio Panetta suggested that the ECB should adopt a more explicit form of yield curve control and should “broadly identify what level of nominal yields it is aiming to achieve” and then allow real yields to fall if inflation expectations rise. But Isabel Schnabel implied that the Bank should try to manage real yields (see Table 2) and allow nominal yields to fluctuate in line with inflation expectations.

On top of that, there is still a role for the 25-member Governing Council in all of this, as they will discuss bond yields in detail next week, despite having delegated the issue to the Executive Board. Not surprisingly, the ECB still makes decisions slowly except in the context of a genuine crisis.

Table 2: Comments by Executive Board Members about the Recent Increase in Bond Yields

Policymaker

Comments

Lagarde

The ECB “is closely monitoring the evolution of longer-term nominal bond yields.”

De Guindos

“We will have to see whether this increase in nominal yields will have a negative impact on financing conditions.”

Lane

“The OIS yield curve and the GDP-weighted sovereign yield curve…deserve particular attention within a holistic and multi-faceted approach to monitoring financing conditions.”

Schnabel

“A too abrupt increase in real interest rates on the back of improving global growth prospects could jeopardise the economic recovery.”

Panetta

“There should be no doubt that lower real yields would provide welcome additional stimulus.”

Elderson

No relevant comments.

Source: ECB

In truth, the ECB’s decisions on when and how much to step up bond purchases within the current policy set-up are more of an art than a science. So unless the Bank changes its policy framework, which is not on the cards for now, there will be a lot of uncertainty about how the Bank will act.

Over the past few weeks, we have been surprised that the Bank has not stepped in to limit the increase in peripheral bond yields, so we are now less confident of how the Bank will respond in future. But in typically slow-moving ECB style, the Executive Board may have been waiting to discuss the moves at next week’s meeting before deciding how to respond. We suspect that the Bank will make another effort to clarify how it will determine whether financing conditions are sufficiently favourable. And on balance, we think that the ECB will probably step up the pace of its purchases somewhat in the coming weeks in order to push bond yields down from their current levels.

Table 2: ECB Background Information and Forecasts

Interest Rate Meetings

Policy setting meeting every six weeks.

Release of minutes

Press conference 45 mins after policy announcement. Minutes four weeks later.

Disclosure of voting

No.

Inflation Target

Asymmetric target of below, but close to, 2.0% over the medium term.

Policy Guidance

Quarterly ECB Staff Macroeconomic Projections (Mar, Jun, Sep, Dec)

Members

25 members of the Governing Council

= 6 members of the Executive Board + 19 Governors of national central banks.

President (tenure, end)

Christine Lagarde, President of the ECB (eight years ending October 2027)

The other 5 members of the
Executive Board

Luis de Guindos, Vice-President of the ECB

Fabio Panetta

Frank Elderson

Isabel Schnabel

Philip Lane, Chief Economist

The 19 Governors

Pierre Wunsch, Governor, Nationale Bank van België / Banque Nationale de Belgique

Jens Weidmann, President, Deutsche Bundesbank

Madis Müller, Governor, Eesti Pank

Gabriel Makhlouf, Governor, Central Bank of Ireland

Yannis Stournaras, Governor, Bank of Greece

Pablo Hernández de Cos, Governor, Banco de España

François Villeroy de Galhau, Governor, Banque de France

Ignazio Visco, Governor, Banca d’Italia

Constantinos Herodotou, Governor, Bank of Cyprus

Martin Kazaks, Governor, Latvijas Banka

Vitas Vasiliauskas, Chairman of the Board, Lietuvos bankas

Gaston Reinesch, Governor, Banque Centrale du Luxembourg

Edward Scicluna, Governor, Central Bank of Malta

Klaas Knot, President, De Nederlandsche Bank

Robert Holzmann, Governor, Oesterreichische Nationalbank

Mário Centeno, Governor, Banco de Portugal

Boštjan Vasle, Governor, Banka Slovenije

Peter Kažimír, Governor, Národná banka Slovenska

Olli Rehn, Governor, Suomen Pankki-Finlands Bank

Policy Meetings

Date

Outcome/Forecast*

2020

23rd January

No change.

12th March

New LTROs; changes to TLTRO-III; increase in APP of €120bn.

18th March

€750bn Pandemic Emergency Purchase Programme.

30th April

PELTROs launched.

6th June

PEPP expanded by €600bn, with net purchase to continue until at least June 2021. Reinvestments under the PEPP will continue until at least the end of 2022.

16th July

No change.

10th September

No change.

29th October

No change.

10th December

PEPP net purchases to continue until at least March 2022, envelope increased to €1.85trn. Three new rounds of TLTROs announced.

2021

21st January

No change

11th March

No change*

22nd April

No change*

10th June

No change*

Sources: ECB, Capital Economics


Andrew Kenningham, Chief Europe Economist, andrew.kenningham@capitaleconomics.com