Konstantin Veit, Portfolio Manager at PIMCO
The ECB meets on Thursday and we expect no material changes to monetary policy. While there will be changes to forward guidance and overall communication to onboard the results of the strategy review, we believe the ECB will likely use this week’s meeting to guide markets towards a more comprehensive assessment of the monetary policy stance in September.
New staff macroeconomic projections and the current March 2022 end date of the pandemic emergency purchase programme (PEPP) offer an opportunity for a more holistic evaluation of the post pandemic policy reaction function in September, incorporating the findings of the freshly concluded strategy review deliberations. We believe the ECB will take the run rate of monthly net asset purchases down over time, from the current €100bn per month to €60bn per month in Q2 2022.
The outcome of the strategy review reaffirms easy monetary policy for a long time, which in itself is a tailwind for risk assets. However, current valuations offer little room for sizeable spread compression, risks to the macroeconomic outlook remain elevated and a regime of hard fiscal dominance elusive.
We believe the new strategy means, by and large, old policy, and cements the revealed preference of maintaining the current monetary policy configuration for longer instead of easing conditions aggressively. The review delivered three main outcomes: a symmetric 2% HICP inflation target effective right away, a multi-year effort to better account for housing related consumer costs in the inflation index, and a broad climate package to be gradually phased in over time.
The ECB currently projects 1.4% HICP inflation for 2023, and in moving its medium-term inflation target up to a symmetric 2% the ECB invites the question of how it will achieve this more ambitious goal from such a low starting point while using the same old tools. And indeed, the strategy review didn’t address specific methods or configurations to reach the new 2% target. Setting a higher inflation target alone without altering the mix of policy therefore does little to assuage doubts that the ECB can achieve its new target. With the policy rate already at the effective lower bound, the ECB’s balance sheet bloated, and nothing new in the toolkit, inflation expectations will likely remain entrenched below 2%. Long-term, market-based measures of inflation expectations have hardly moved since the strategy review announcement and remain stuck around 1.5%.
This week we expect the ECB to update its forward guidance on interest rates, as the current language references the previous definition of price stability. The format of the introductory statement, renamed into “monetary policy statement” will change as well. The ECB previously used a twin pillar approach to determining the appropriate monetary policy stance: the economic pillar assessing short to medium-term risks to price stability, cross-checked against the monetary pillar assessing medium to long-term trends in inflation.
Going forward, the ECB’s monetary policy deliberations will be based on a revised integrated analytical framework that brings together an economic analysis and a monetary and financial analysis, where the latter examines monetary and financial indicators with a focus on the operation of the monetary transmission mechanism and possible risks to medium-term price stability from financial imbalances and monetary factors.
The policy statement will no longer refer to the notion of cross-checking between pillars, but will set out a narrative motivating the policy decision. It will also be streamlined, its clarity improved and language simplified, with a view of making it accessible to a broader audience. We don’t believe the ECB will provide much clarity on life after PEPP this week.
September and beyond:
The Governing Council will revisit the purchase pace of the PEPP against a fresh round of quarterly macroeconomic projections in September. The ECB currently buys €80bn per month under the PEPP and €20bn per month under the regular asset purchase programmes (APP). Once the pandemic-related effects on the inflation path are sufficiently neutralized via temporary policy measures like the PEPP and subsidized liquidity provisions, we believe more regular asset purchase tools will come back to prominence in order to fine-tune the post-pandemic monetary policy stance from 2022 onwards, while interest rate cuts will remain on the back-burner.
In our view, the strategy review results institutionalize the recent ECB pivot from intensity to duration of monetary policy support, which is reflected in a strong focus on persistence of monetary policy action close to the lower bound on interest rates. We expect the PEPP to end next year, potentially as early as March 2022, and expect the regular APP to be upsized from €20bn to €60bn per month in return, as progress towards the 2% medium-term inflation aim remains meagre.
We would also expect the ECB to maintain the practice of regular joint assessments of financing conditions and inflation outlook to derive asset purchase quantities, and to emphasize existing APP flexibilities, particularly in relation to an impaired transmission mechanism which should dispel concerns about ability and willingness to deviate from the capital key as needed.