ECB diverges from the Fed and BoE

ECB View: Big slowdown of asset purchases but no rate hike in sight

The ECB announced the end of net asset purchases under the PEPP as expected, but also a number of policy changes, which could help cushion the blow. Perhaps the most interesting element of today’s press conference, however, is that the ECB expects inflation to undershoot its goal even at the very end of 2024 with no sign of any increase towards the end of the horizon. If this forecast proves correct, it is difficult to see how the conditions for a rate hike will be met in the coming years. Of course this is quite a difference from the Fed (see here) and BoE (see below) that expect inflation to settle above their respective targets over the medium term. Indeed, the BoE embarked on a rate hike cycle today, while the Fed will do so next year.

Slowdown of asset purchases

The ECB confirmed that the PEPP will end in March 2022 and that purchases will slow further up until that point. However, it also announced a number of policy changes to offset the impact of this.

First, the minimum horizon for reinvestments under the PEPP was extended to the end of 2024 (previously end 2023) and it signalled flexibility in the reinvestment policy based on market circumstance. In particular, in the event of renewed market fragmentation related to the pandemic, PEPP reinvestments could be adjusted flexibly across time, asset classes and jurisdictions at any time, including skewing towards Greek bond. Second, it signalled that net purchases under the PEPP could be resumed, if necessary, to counter negative shocks related to the pandemic. Third, it will temporarily increase the APP pace (to EUR 40 billion in Q2 and EUR 30 billion in Q3) and retained the commitment to continue to run the net purchases at EUR 20bn beyond that until shortly before it starts raising the key ECB interest rates (‘shortly before’ has been defined at 6-12 months by some GC members). Although all this still points to a sharp slowdown in the pace of purchases, given the outlook for policy rates (see below) it seems likely that the APP will run well past next year.

A long period of unchanged policy rates

Meanwhile, the central bank’s inflation forecasts combined with its forward guidance signal that policy rates will be left on hold in the coming years. As explained in more detail below, inflation is seen at 1.8% even at the very end of 2024 with no sign during the course of that year of any kind of upward trend that would bring inflation to 2% in 2025. The ECB’s forward guidance states that the Governing Council expects ‘key ECB interest rates to remain at their present or lower levels until it sees inflation reaching 2% well ahead of the end of its projection horizon and durably for the rest of the projection horizon’. Well ahead has been defined at 12 – 18 months. So it is difficult to see that condition being met during the ECB’s forecasting horizon if the central bank’s projections for inflation turn out to be right. ECB President Lagarde was cautious in going that far in the press conference, saying only a 2022 rate hike is unlikely. That may reflect that there is high level of uncertainty about the inflation outlook. However, if inflation does start to come down as it expects and the ECB is more confident that it is returning to a lowflation world, its commentary might become more dovish.

ECB expects inflation to be below the target in 2024

The ECB’s updated Staff Macroeconomic projections include a longer lasting impact of the pandemic on growth and inflation. As a result, it has lowered its growth forecast for 2021Q4 and 2022Q1 and raised its forecasts for 2022Q2-Q3. Consequently, the projection for GDP growth in 2022 was lowered (to 4.2%, down from 4.6% in the September projections) and the forecast for 2023 was raised (to 2.9% from 2.1). The year 2024 was added to the Central Bank’s forecasting horizon. Growth is expected to be 1.6% that year, which is roughly equal to the trend rate.

The ECB’s inflation forecasts now also include a longer lasting impact of the pandemic, which means a longer period of discrepancies between global supply and demand of certain goods. Moreover, the technical assumption about oil prices and other commodity prices in 2022 have jumped higher (by 15% and 33%, respectively compared to the September forecasts). Consequently, the forecasts for headline inflation in 2022 jumped to 3.2%, up from 1.9% in September. During the press conference, Christine Lagarde explained that two-thirds of this upward revision was due to energy price inflation. Looking beyond the disturbances from the pandemic, inflation is expected to decline to 1.8% in 2023 and to stabilise at that level in each quarter throughout the end of 2024.

Monitoring bank funding conditions

Finally, the ECB did not make any changes with regards its policies for the banking system, though it committed to monitoring the situation. It confirmed that it expects ‘special conditions applicable under TLTRO III to end in June next year’. However, it ‘will continue to monitor bank funding conditions and ensure that the maturing of TLTRO III operations does not hamper the smooth transmission of its monetary policy’. In addition, it will ‘assess the appropriate calibration of its two-tier system for reserve remuneration so that the negative interest rate policy does not limit banks’ intermediation capacity in an environment of ample excess liquidity’. This suggests that the ECB has not closed the door to introducing further TLTRO tranches or improving conditions, or increasing the tiering multiplier. However, we do not expect any of these changes in our base case, given that financing conditions remain favourable.

BoE View: 15bp rate hike, with more to come in 2022

The MPC voted 8-1 to raise Bank Rate by 15bp to 0.25% today, against consensus expectations for policy to be on hold, but in line with our forecast. In the policy statement, the Committee acknowledged the downside risks to growth from the spread of Omicron, but noted that “its impact on medium-term inflationary pressures is unclear at this stage.” At the same time, "the labour market is tight and has continued to tighten, and there are some signs of greater persistence in domestic cost and price pressures.” The inflation forecast was further upgraded following the upside surprise in the November CPI reading, with the peak now projected to be nearer 6% in the spring, up from 5% previously. While inflation is still expected to moderate in the course of 2022, the Bank of England’s own projections suggest inflation will stay above target in the medium term in the absence of further rate hikes. Our base case continues to be for a further two 25bp hikes in February and August, taking Bank Rate to 0.75%, and another two such hikes in 2023, taking rates to 1.25%.