ECB concerns about inflation expectations to come to the fore
ECB to maintain optionality but hawkish tone to intensify - The ECB’s Governing Council meets this week to discuss monetary policy. Given the high levels of uncertainty, it will likely want to maintain the optionality and flexibility that has become the new cornerstone of its approach. However, the hawkish tone is likely to intensify, leaving no doubt that the most likely outcome in coming months is an end to net asset purchases and subsequently higher policy rates.
The case for a more hawkish ECB
This reflects three key elements. First, inflation expectations are on the way up and if this trend continues, they could reach levels that are no longer consistent with the inflation target. The 5y5y inflation swap has spiked over recent weeks (see chart) and although the ECB looks at a broader range of indicators to track expectations, these have also moved up and market data is the most up to date. Second, although the current shock will lead to higher inflation and lower economic growth, the ECB has more concrete evidence that the former is materialising than the latter. Third, the tightening of financial conditions has reversed and the overall level of these is roughly neutral despite the hawkish central bank communications and actions we have seen so far this year.
Factors that could temper the ECB’s hawkishness going forward
Of course looking further forward, some of these elements could start to shift. More evidence of economic growth being seriously impacted, beyond what is factored into the ECB’s projections, could become a counterweight to the upside near-term inflation surprises. Deterioration in the economic outlook and signs of a peak in headline inflation could also help to dampen inflation expectations. Finally, against this background a renewed market correction could tighten financial conditions. These developments could temper the eventual speed and extent of policy rate hikes, though the bar to any further extension of QE seems very high.
A new tool aimed at preventing fragmentation
The ECB’s signals that monetary policy will be normalised have gone hand in hand with the message that it would fight against fragmentation. This means that it would act in case sovereign spreads were to rise significantly. With net purchases under the APP ending, skewing PEPP reinvestments would be the first port of call to limit any rise in spreads. However, the ECB seems to be concerned that this may not be enough to do the job. The Governing Council seems to be considering a new tool with this in mind.
The precise nature of the tool and the timing of any announcement are uncertain, but one could imagine a new asset purchase programme that could come into place in the case of surging spreads. Unlike the APP, purchases could be focused only on the countries with sharply higher spreads, while the tool could be deployed even against the background of rising policy rates. So fighting fragmentation and policy normalisation could then go hand in hand. Arguably the signalling of putting such a tool in place reduces the chances that it would ever need to be used.
What is the case for policy normalisation?
It is very doubtful whether the end of net asset purchases and policy rate hikes will do much to dampen the sharp rise in inflation in the near term. Much of the inflation we are experiencing is imported (energy, supply chain bottlenecks) rather than driven by strong domestic demand. One could argue that policy normalisation will strengthen the euro or at least reduce the extent of its fall, which can reduce imported inflation. In addition, monetary policy signals could be aimed at re-anchoring inflation expectations, though there are serious question marks about whether this would be a successful endeavour. For instance, US inflation expectations have continued to accelerate despite markets pricing in an aggressive Fed rate hike cycle and QT. Finally, the impact of monetary policy on demand works with a lag and it could be argued that by the time it comes through, the supply-driven inflation would have already started to abate.
Perhaps the most convincing argument for normalisation is that accommodative monetary policy is no longer required. Unemployment is historically low and we are no longer witnessing persistent undershoots of the inflation goal, but rather the opposite. However, this raises the question of how far from normal policy rates are. For sure, most of estimates of the neutral rate put it significantly above current levels. Though one reason for doubt is that demand has hardly been sizzling over the years in which negative rates have been in place.