When will ECB pare back monetary stimulus?

ECB President Christine Lagarde said, the ECB wants to see inflation head to 2% by the mid-point of its forecast horizon.

After a slow start, the vaccine rollout has gathered pace but still lies behind the faststarters such as the UK and US. For instance, around more than a half of the populations of the US and UK are fully vaccinated, while the figure in most euro zone nations varies from a quarter to a third. One upshot of this is that the euro zone economic recovery seems to be lagging the US, for instance, by between one and two quarters. The degree of recovery also seems to be less. The US has just about recovered the GDP lost during the pandemic but the euro zone could take until the first half of next year to recover all the output lost. Growth should be around 4.5% this year and, while the ECB believes that next year could be stronger at 4.7%.

It remains to be seen if the recovery in the economy will give rise to the price pressures, we have seen in some of the countries that are a bit further ahead than the euro zone in their post-pandemic rebound. Core CPI inflation in the euro zone is now hovering around the 1% level, which is below pre-pandemic levels, whereas the US has seen core CPI and PCE prices surge on a combination of supply chain problems and rebounding demand.

ECB President Christine Lagarde said, the ECB wants to see inflation head to 2% by the mid-point of its forecast horizon, which currently stretches to 2023 and is extended by one year every December, and that any deviation above the target should be incidental.

The ECB’s forecasts do not make for very positive reading either as the spurt in the headline rate to 1.9% this year is followed by a dip to 1.5% in 2022 and 1.4% in 2023, according to the Standard Bank’s latest forecasts. That’s still short of the “close to, but below 2%” target the ECB seeks to achieve. This target could be changed when the ECB completes its strategy review. This could come as early as September and should definitely be out before the end of the year.

“We think there is a good chance that the ECB stresses the symmetry it would like to see in the target even if we doubt that it will follow the same average inflation target mechanism that the Fed has introduced recently. Even if the inflation target is still ostensibly higher than before it is of little use unless the ECB has a means of achieving it and, on this point, there must be question marks. Still, it seems likely that the ECB will press for a fuller gamut of housing-related costs to be included in the CPI, something that many nations have been pushing for given the strength of house prices and rents. This is something that could, conceivably, lift inflation slightly but clearly it would be a pyrrhic victory if this allowed the ECB to hit its near-2% target more easily”, Mr. Steve Barrow, Head of Standard Bank G10 Strategy said.

With achievement of the inflation target still out of sight, it still looks as if the first rate hike from the ECB, at least in terms of the key refi rate, will be some years away; possibly further than the eye can see, just as we’ve experienced with Japan. However, the Standard Bank said, the ECB should still be able to pare back the stimulus from quantitative easing once its EUR1.85tr target for the Pandemic Emergency Purchase Programme (PEPP) is hit next March.

We certainly don’t think that net bond purchases will be stopped altogether at this point. Indeed, the old Asset Purchase Programme of EUR20bn per month will carry on and, in our view, be topped-up to meet some of the reduction resulting from the ending of the PEPP. The prospect of more government bond supply being available to the private sector, as the ECB steps away, should help lift yields, as should the recovering economy and the “pull” from higher treasury yields. These increases in bond yields probably won’t lift the euro given that many other bond markets, particularly the US treasury market, will likely see yields rise much more. However, it is real (inflation adjusted) yields that are key and, on this score, we feel that the US’s more significant inflation risk means that higher nominal treasury yields are unlikely to give the dollar much of a lift. Add to this the catch-up in the euro zone economic recovery and the much stronger balance of payments position, and it suggests to us that the longer-term directional skew for euro/dollar is to the high side — and hence we have a target range of 1.30-1.40 over the next year or two, forcasted Mr. Steve Barrow.