PIMCO: ECB Preview – Waiting for December

The ECB meets on Thursday and we don’t expect changes to monetary policy or the President to front run the December meeting deliberations.

At the December meeting, the Governing Council will publish new macroeconomic projections, including its inaugural assessment for 2024, as well as communicate the game plan for quantitative easing after the current Pandemic Emergency Purchase Programme (PEPP) ends in March 2022. The ECB currently buys around €70bn per month under the PEPP, plus €20bn per month under the regular Asset Purchase Programme (APP).

While we do not have a strong view on the mix of asset purchase acronyms beyond March 2022, we do think the Governing Council will avoid a cliff-effect on asset purchases and choose instead to gradually reduce the pace from the current €90bn per month to a steady-state rate between €40-60bn per month over Q2 next year.

We also think the ECB will maintain the current framework of revisiting the pace of asset purchases on a quarterly basis, with a view to gradually relegating them from a duration extraction tool to a pure policy rate signaling device over time.

Finally, we expect the ECB to announce additional Targeted Longer-term Refinancing Operations (TLTROs) in December, although at less generous terms than during the pandemic crisis phase.

Additional thoughts:

· December and beyond: The ECB currently buys around €70bn per month under the PEPP, and €20bn per month under the APP. Once the pandemic-related effects on the inflation path are sufficiently neutralized, via temporary policy measures like the PEPP and subsidized TLTRO liquidity provisions, we think more regular asset purchase tools will come back to prominence in order to fine-tune the post-pandemic policy stance from 2022 onwards. The strategy review results institutionalize the recent ECB pivot from intensity to duration of monetary policy support, which is reflected in a focus on persistence of the current monetary policy stance. What matters to the monetary policy stance is the total amount of asset purchases, with the split amongst programs largely a political decision. We expect the PEPP to end in March 2022, and expect the regular APP to be upsized from the current €20bn per month in return, as progress towards the 2% medium-term inflation aim remains incomplete. We think the differences between PEPP and APP are manageable, mainly confined to minor discrepancies regarding front end maturities and the ratings related exclusion of Greek government bonds under the APP. Hence, we do not think major changes to the APP, or the introduction of yet another purchase programme, are needed. But the ECB could certainly decide to introduce a temporary purchase envelope to smooth the transition from PEPP back to an APP only world.

We would also expect the ECB to maintain the practice of regular joint assessments of financing conditions and inflation outlook to derive asset purchase quantities, and to emphasize existing APP flexibilities, particularly in relation to an impaired transmission mechanism, which should dispel concerns about ability and willingness to deviate from the capital key as needed. The Governing Council will almost certainly introduce additional TLTROs in December, although we do not think the ECB will extend the pandemic related -1% special interest rate period beyond June 2022. If the ECB decides not to extend the -1% borrowing rate, it could decide to adjust the tiering multiplier in return, to at least partially compensate banks for reduced TLTRO relief from the impact of the negative policy rate on profitability. Excess liquidity in the Euro area currently stands at €4.4trn, versus €1.7trn when tiering, under which part of banks’ holdings of excess liquidity are exempt from the negative deposit facility rate, which was first introduced in September 2019. Instead of regularly introducing additional operations, the ECB might eventually decide to institutionalize TLTROs as a permanent part of the policy framework.

· The ECB’s new strategy: We believe the new strategy means, by and large, the old policy in new clothes and it cements the Governing Council’s revealed preference of maintaining the current monetary policy configuration for longer instead of easing conditions aggressively. The ECB currently projects 1.5% HICP inflation for 2023 and in moving its medium-term inflation target up to a symmetric 2%, the ECB invites the question of how it will achieve this more ambitious goal from such a low starting point without introducing new tools. The strategy review did not address the specific methods or configurations of how to reach the new 2% target. Setting a higher inflation target alone without altering the policy mix therefore does little to assuage doubts that the ECB can achieve its new target and runs the risk of entrenching inflation expectations below target.

We believe the new forward guidance on policy rates serves mainly the purpose of avoiding mistakes of the past by of tying the Governing Council to the mast and avoiding premature tightening (APT) of monetary policy. We believe the new forward guidance on policy rates implies that the ECB would now have to project inflation at 2% for the two years following the current year, i.e. out to 2024; and probably core inflation above 1.6% and on an increasing trend, before it considers hiking interest rates. While the ECB’s APT policy is intended to reassure markets that the ECB will remain patient and won’t repeat the hawkish mistakes of 2008 and 2011, that focus on defense also suggests there won’t be any serious attempt to credibly close the longstanding gap between the inflation target and projected inflation. In addition, pivoting away from asset purchases back to policy rates as the primary monetary policy tool at the effective lower bound on interest rates introduces a hawkish asymmetry to the ECB reaction function. Similar to the Bank of Japan, the ECB is now firmly focused on persistence and sustainability of its monetary policy measures and less so on achieving the inflation target within a reasonable horizon.

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Source: PIMCO (By Konstantin Veit, Portfolio Manager at PIMCO)