The governing council of the European Central Bank holds a scheduled policy meeting on Thursday followed by a press conference with the ECB’s president and vice-president.
We do not expect the central bank to act at this policymaking meeting – that is, no change in the key ECB interest rates, no change in the asset purchase programmes, and no change in the forward guidance.
We do expect the ECB to talk a good game by signalling that the governing council is willing to act – in particular, highlighting the attention it is paying to key developments (inflation, the euro exchange rate) and its willingness to use all the policy levers in the toolbox in response (while stressing that the deposit rate is not at the lower bound).
As with all policy meetings, there will be the standard discussion of the news in the data. In this particular case, the focus will be on the current momentum in activity and the source of the weakness in core inflation. Discussion of the following issues could feature in the press conference.
Most central bankers do not like talking in public about the currency. However, central bankers do not have the luxury of ignoring it. A significant appreciation of the nominal effective exchange rate – of the kind that has occurred in the eurozone in recent months – will have implications for the macroeconomic outlook, depressing activity and prices. The question is how to respond.
The fact of the matter is that exchange rate appreciation will likely lead to weaker import prices. Indeed, that disinflationary impulse should be captured in the latest set of ECB staff projections and could easily undo all the positive impact from whatever assumptions the ECB staff make about the positive impact of the Next Generation EU (NGEU) package (on the utilisation of loans and on the use of grants).
With inflation already far too low, it is difficult to be sanguine about any further source of disinflation.
The natural tool to respond to an appreciation of the euro is thought to be a cut in the deposit rate, on the premise that currencies are more sensitive to differentials in short-term interest rates.
The problem here is that the deposit rate may already be close to the lower bound, or a related concept called the reversal rate – the point at which cuts in the policy rate become counterproductive and contractionary via the banking channel.
It also has to be borne in mind that the reversal rate (and hence the lower bound) rises over time – that is, negative rates become more painful for banks as time passes unless mitigating measures such as tiering are taken.
Revealed preference suggests that the governing council believes that the deposit rate is close to the lower bound. After all, while the COVID-19 pandemic led to the greatest negative economic shock in living memory, the deposit rate was left unchanged.
Of course, even if the council has reached this conclusion, it is unlikely that it would want to announce this view to the market because the result would likely be a counterproductive tightening in financial conditions as any expectations of further cuts were removed from pricing.
The ECB has also developed a couple of mitigants to cushion the blow of negative rates on the banking sector: a two-tier system of remunerating excess reserves and lending funds to the banks at a rate below the deposit rate (via the TLTRO).
The ECB could certainly make more use of these tools if it concluded that a further cut in the deposit rate was necessary. In fact, one thing that is striking about the ECB communication on the deposit rate is how little the executive board has said about these mitigants and the constraints on their use. Negative rates weigh heavily, not just on banks, but the mitigants support only banks.
Before cutting the deposit rate, we believe that the governing council will first try to talk the euro down through verbal intervention, highlighting in particular its willingness to cut the deposit rate in the future.
The answer here is clear: yes. The previous set of ECB staff projections had core inflation stuck at below 1%. Of course, core inflation has been stuck near 1% for a considerable time in Europe (see Exhibit 1 below).
There is a real risk that inflation expectations settle at this new level if they have not already done so, and that would make the task of returning inflation to the target even harder still. The fact that core inflation has just fallen to a record low (0.4%) should just add an extra sense of urgency. More needs to be done, and given the size of the medium-term inflation shortfall, a lot more.
ECB Chief Economist Philip Lane seemingly made the case for an aggressive policy response in his recent speech. He argued for a two-stage plan in which the ECB would first offset the impact of the pandemic on the inflation outlook, and second, once that had been achieved, the ECB would set the stance of policy to “to ensure timely convergence to our medium-term inflation aim.” These are laudable aims. Unfortunately, it would appear that the ECB is still some distance from successfully completing stage one. We doubt the projections published this week will alter that observation.
There appears to be a clear allocation of tools to the two stages of Lane’s plan: asset purchases under the Pandemic Emergency Purchase Programme (PEPPP) are supposed to deliver stage one, and then asset purchases under the Asset Purchase Programme (APP) deliver stage two.
If the inflation forecasts remain as weak as we expect, it follows from the Lane doctrine that the ECB should this week announce an increase in the PEPP to make meaningful progress towards completion of stage one. However, we do not expect such an announcement. Instead, we expect another verbal intervention, with the council protesting that it is monitoring the inflation outlook closely and willing to use all available tools: PEPP and APP included.
We suspect that December is the earliest likely date at which the council would announce another expansion of the PEPP.
Fed Chair Jay Powell’s speech at the (virtual) Jackson Hole conference that unveiled a new strategy of (flexible) average inflation targeting (AIT) inevitably put the spotlight back on the ECB, raising questions about the ECB’s policy framework and whether the ECB could tolerate an overshoot in inflation to compensate for persistent undershoots.
In some sense, the answer here is easy: the ECB strategy review is still in its early stages (it is not expected to conclude until the second half of next year), so it would be unreasonable to expect President Christine Lagarde to offer firm conclusions now.
She is likely to state that the governing council is exploring all options; that AIT has some interesting features; that the council views the current inflation target as symmetric and not a ceiling; and she may even acknowledge that current and former members of the governing council have expressed similar sentiments.
The ECB could conceivably follow the Fed’s example because flexible average inflation targeting is a modest change (improvement) on conventional inflation targeting. Admittedly, the central bank is obliged to deliver an overshoot in a boom, but there is no commitment device forcing the central bank to engineer overshoots on a significant scale or according to a specific timetable. In its weakest form, AIT sounds more like an aspiration than a commitment. The governing council could probably sign up to such an aspiration.
In contrast, it seems harder to imagine the ECB adopting a price level path target because that involves a commitment device: a constant (and increasing) quantitative reminder of the central bank’s failure to deliver overshoots.
There is a real risk that the ECB has exhausted the ammunition that it is comfortable deploying and therefore lacks the means to achieve an inflation overshoot.
The success or failure of AIT in the eurozone would therefore depend on the stance of fiscal policy – much as it does in the US (except that the ECB faces an even more formidable challenge in delivering overshoots). The ECB’s governing council might well be nervous about adopting a new more ambitious target when it does not believe it can easily hit the current one.
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