The ECB needs to follow the talk with the walk

Implications for the policy outlook

Commitment to the new framework is key to sustainably achieving the inflation target. As signalled by ECB President Lagarde, existing forward guidance will need to be updated to reflect the new framework, which we expect may occur at the policy meeting on July 22.  The guidance also needs to be strengthened, perhaps with a link to inflation outturns rather than forecasts.  This change would signal a strong commitment to stay the course and avoid a premature monetary tightening in the face of overly optimistic projections.

Based on its policy actions since the start of the pandemic, it is clear that the Governing Council sees asset purchases as the policy tool to do the heavy lifting, particularly as it pertains to long-term rates. This view is reinforced by recent ECB analysis regarding the effectiveness of quantitative easing, which projected that the euro area 2019’s GDP growth and inflation would have been 1.1 percentage point and 0.75 percentage points lower, respectively, without a negative policy rate and asset purchases.

While the debate about the ultimate effectiveness of QE continues, in addition to the purchasing demand, asset purchases also act as a policy signal that boosts confidence and reduces uncertainty.  This sentiment channel can be reinforced by forward guidance that projects an accommodative policy as long as needed to return inflation to target.

Perhaps as early as September, we expect a decision on the scaling up of QE under the existing Asset Purchase Programme (APP) beyond March 2022, which is when the current pandemic emergency asset purchase programme (PEPP) is due to end.  The large gap between the ECB’s forecast for inflation of 1.4% by the end of 2023 and its new 2% inflation target suggests a significant increase in APP purchases beyond March. Indeed, we project that APP purchases could expand by as much as four-fold – from the current open-end run rate of €20bn to approximately €80bn per month (Figure 2). That top end estimate would equate to an additional €720bn over 12 months, similar in magnitude to the asset purchase announcements made at the height of the pandemic in March 2020. Complementary adjustments, such as increased flexibility in APP operations, will also be needed to ensure that the ECB has ample discretion.

Resetting the credibility benchmark

Although the stated details of the ECB’s framework revision continue to underwhelm some participants, we see the new regime as a clear delineation from past policy. Granted, the main policy rate may remain stagnant near current levels, but it may do so for the foreseeable future. The rate accommodation, coupled with updated, strengthened forward guidance (possibly as soon as next week), ample capacity to boost open-ended asset purchases, and targeted long-term refinancing operations, places the ECB’s framework in a new paradigm that is better suited to address the region’s chronically weak inflation.

The announcement of the revised framework also sets another benchmark on which its policy credibility will be judged. Thus, its future effectiveness as an institution relies on backing its talk with the policy walk.

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