ECB – Still erring on the side of caution

The European Central Bank held its penultimate monetary policy meeting of the year on Thursday, October 28. There were no major new developments, with the last meeting of the year in December more likely to see the announcement of more policy shifts, if any. However, the underlying tone of recent comments from Governing Council members suggests that the majority are not overly concerned about the rise in inflation this year and are willing to err on the side of caution and tolerate an ultra-easy policy stance for as long as necessary. In other words until they are convinced the Eurozone economy is on a stable and sustained footing.

After its September 9 meeting the ECB said that it had decided to move to “a moderately lower pace” in its €1.85 trillion pandemic emergency purchase programme (PEPP) from the €80bn-a-month level it has run at since March. The decision to slow the PEPP, the ECB’s flagship policy bond-buying response to the pandemic, follows a strong rebound in Eurozone economic growth and a surge in inflation to a decade-high, as rising coronavirus vaccinations have helped to end lockdowns and boosted business and household activity. But borrowing a famous line from the late UK Prime Minister Margaret Thatcher that “the lady’s not for turning”, ECB president Christine Lagarde said at the September monetary policy press conference that the unanimously agreed shift to a slower pace of purchases was not tapering. The ECB said the programme would continue until at least March 2022, or until the Governing Council decided “the coronavirus crisis phase” was over. Even at a reduced pace of €60bn to €70bn a month, the PEPP still has enough firepower to soak up all the new debt issued by Euroland governments for the rest of the year.

Most analysts and bond traders agreed that the ECB’s decision was different to other central banks’ unwinding of monetary support because it is not planning to end its bond-buying just yet and is only “recalibrating” its pace. Indeed, it looks like asset purchases are here to stay as the new policy framework paves the way for looser-for-longer monetary policy in the Eurozone.

Lagarde said the decision to slow bond purchases reflected an improvement in financing conditions in recent months and signs that the “rebound phase in the recovery of the euro area economy is increasingly advanced” with 70% of adults having been vaccinated. However, she cautioned “there remains some way to go before the damage done to the economy by the pandemic is undone,” adding that 2 million more people were out of work than before the pandemic and many more were still on furlough schemes. “We are not out of the woods.” Lagarde said the risks for the economic outlook were “broadly balanced” and “price pressures are building only slowly”. The ECB’s chief economist, the highly respected Philip Lane, is another who believes that the upward move in inflation is only transitory, caused in the main by supply chain disruptions as a result of Covid. In fact, the latest economic forecasts from ECB staffers point to inflation falling back again below target over the next couple of years. And Lagarde in her October press conference said that financial markets appeared to be pricing in official rate-hikes or a rate “lift-off”, much sooner than the central bank itself.

Personally, I’m not convinced that inflation is only temporary, with prices rising all across the board as businesses try to recoup the losses they incurred as a result of prolonged closures and consumers, buoyed by record savings, are gladly willing to spend, irrespective of the price, as economies start to return to some sort of normality. As a result, I think the ECB will be forced into remedial action sooner than it thinks, but the “doves” on the Governing Council seem willing to tolerate higher inflation for longer than would have been the case in the past, which suggests that even if interest rates do rise it won’t be by very much.

A key question raised by some in the market recently is whether Germany and its fellow debt “hawks” would try in the coming months to reign in the ECB’s programme of bond purchases. Or will the debt hawks do nothing except grumble, as they have for months now? Well the answer may have come from the announcement in mid-October that Bundesbank president and main ECB ”hawk” Jens Weidmann is stepping down at the end of the year after 10 years in office, citing personal reasons. While Weidmann may genuinely have health or family issues, there are many who believe, that like his predecessor, Axel Weber, who also jumped ship early, the German central banker has simply become frustrated at the direction the ECB is taking, with the “doves” clearly calling the shots in recent years and likely to do so for some time to come the way things currently stand.

In his resignation statement, Weidmann said he continues to firmly believe the ECB should stick with its original narrow mandate of controlling inflation. “A stability-oriented monetary policy will only be possible in the long run if the regulatory framework of the Monetary Union continues to ensure the unity of action and liability, [and] monetary policy respects its narrow mandate and does not get caught in the wake of fiscal policy or the financial markets,” he wrote. That comment may be a nod to ongoing discussions on the Governing Council to transfer some of the flexibility of the pandemic-induced asset purchase programme to previously existing programmes. This move would allow the ECB to focus its government bond purchases on individual member states, thereby removing spreads in borrowing costs and, arguably, reducing the incentive for sound fiscal policies and the need for higher official interest rates.

For those who continue to ask whether the era of zero Eurozone interest rates is here to stay, the simple answer is yes, or at least until the “hawks” are back in the majority on the ECB’s 25-member Governing Council. But as of now, it looks like the central bank “doves” will continue to call the shots for the immediate future, suggesting that an increase in the deposit rate from -0.50% at present and the main refinancing rate from zero is unlikely until 2023 at the earliest. It may be the sharp upward move in Euroland inflation, if sustained, wakes the “doves” from their slumber, but that’s probably more wishful thinking on my part. However, in my view it is naïve to believe that ultra-loose monetary policy for a prolonged period won’t have serious negative consequences down the road.

Author: Alan McQuaid is a leading economist and media commentator in Ireland. He has worked with the Department of Finance and the leading Irish stockbroking companies.