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ECB may not be able to hike rates/normalize even by 2024-25

calendar 02/04/2021 - 17:47 UTC

On 11th Mar, ECB President Lagarde said in her ECB presser: Opening statement

While the overall economic situation is expected to improve over 2021, there remains uncertainty surrounding the near-term economic outlook, relating in particular to the dynamics of the pandemic and the speed of vaccination campaigns. The rebound in global demand and additional fiscal measures are supporting global and euro area activity. But persistently high rates of coronavirus (COVID-19) infection, the spread of virus mutations, and the associated extension and tightening of containment measures are weighing on euro area economic activity in the short term.

Looking ahead, the ongoing vaccination campaigns, together with the envisaged gradual relaxation of containment measures, underpin the expectation of a firm rebound in economic activity in the course of 2021. Inflation has picked up over recent months mainly on account of some transitory factors and an increase in energy price inflation. At the same time, underlying price pressures remain subdued in the context of weak demand and significant slack in labor and product markets. While our latest staff projection exercise foresees a gradual increase in underlying inflation pressures, it confirms that the medium-term inflation outlook remains broadly unchanged from the staff projections in December 2020 and below our inflation aim.

In these conditions, preserving favorable financing conditions over the pandemic period remains essential. Financing conditions are defined by a holistic and multifaceted set of indicators, spanning the entire transmission chain of monetary policy from risk-free interest rates and sovereign yields to corporate bond yields and bank credit conditions.

Market interest rates have increased since the start of the year, which poses a risk to wider financing conditions. Banks use risk-free interest rates and sovereign bond yields as key references for determining credit conditions. If sizeable and persistent, increases in these market interest rates, when left unchecked, could translate into a premature tightening of financing conditions for all sectors of the economy. This is undesirable at a time when preserving favorable financing conditions still remains necessary to reduce uncertainty and bolster confidence, thereby underpinning economic activity and safeguarding medium-term price stability.

Against this background, the Governing Council decided the following:

First, we will continue to conduct net asset purchases under the pandemic emergency purchase programme (PEPP) with a total envelope of €1,850 billion until at least the end of March 2022 and, in any case, until the Governing Council judges that the coronavirus crisis phase is over. Based on a joint assessment of financing conditions and the inflation outlook, the Governing Council expects purchases under the PEPP over the next quarter to be conducted at a significantly higher pace than during the first months of this year.

We will purchase flexibly according to market conditions and with a view to preventing a tightening of financing conditions that is inconsistent with countering the downward impact of the pandemic on the projected path of inflation. In addition, the flexibility of purchases over time, across asset classes, and among jurisdictions will continue to support the smooth transmission of monetary policy. If favorable financing conditions can be maintained with asset purchase flows that do not exhaust the envelope over the net purchase horizon of the PEPP, the envelope need not be used in full. Equally, the envelope can be recalibrated if required to maintain favorable financing conditions to help counter the negative pandemic shock to the path of inflation.

We will continue to reinvest the principal payments from maturing securities purchased under the PEPP until at least the end of 2023. In any case, the future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance.

Second, net purchases under our asset purchase programme (APP) will continue at a monthly pace of €20 billion. We continue to expect monthly net asset purchases under the APP to run for as long as necessary to reinforce the accommodative impact of our policy rates, and to end shortly before we start raising the key ECB interest rates.

We also intend to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when we start raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

Third, the Governing Council decided to keep the key ECB interest rates unchanged. We expect them to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2 percent within our projection horizon, and such convergence have been consistently reflected in underlying inflation dynamics.

Finally, we will continue to provide ample liquidity through our refinancing operations. In particular, our third series of targeted longer-term refinancing operations (TLTRO III) remains an attractive source of funding for banks, supporting bank lending to firms and households.

Preserving favorable financing conditions over the pandemic period for all sectors of the economy remains essential to underpin economic activity and safeguard medium-term price stability. We will also continue to monitor developments in the exchange rate with regard to their possible implications for the medium-term inflation outlook. We stand ready to adjust all of our instruments, as appropriate, to ensure that inflation moves towards our aim in a sustained manner, in line with our commitment to symmetry.

Let me now explain our assessment in greater detail, starting with the economic analysis. Following the strong rebound in growth in the third quarter of 2020, the euro area real GDP declined by 0.7 percent in the fourth quarter. Looking at the full year, real GDP is estimated to have contracted by 6.6 percent in 2020, with the level of economic activity for the fourth quarter of the year standing 4.9 percent below its pre-pandemic level at the end of 2019.

Incoming economic data, surveys, and high-frequency indicators point to continued economic weakness in the first quarter of 2021 driven by the persistence of the pandemic and the associated containment measures. As a result, real GDP is likely to contract again in the first quarter of the year.

Economic developments continue to be uneven across countries and sectors, with the services sector being more adversely affected by the restrictions on social interaction and mobility than the industrial sector, which is recovering more quickly. Although fiscal policy measures are supporting households and firms, consumers remain cautious in the light of the pandemic and its impact on employment and earnings. Moreover, weaker corporate balance sheets and elevated uncertainty about the economic outlook are still weighing on business investment.

Looking ahead, the ongoing vaccination campaigns, together with the gradual relaxation of containment measures – barring any further adverse developments related to the pandemic – underpin the expectation of a firm rebound in economic activity in the course of 2021. Over the medium term, the recovery of the euro area economy should be supported by favorable financing conditions, an expansionary fiscal stance, and a recovery in demand as containment measures are gradually lifted.

This assessment is broadly reflected in the baseline scenario of the March 2021 ECB staff macroeconomic projections for the euro area. These projections foresee annual real GDP growth at 4.0 percent in 2021, 4.1 percent in 2022, and 2.1 percent in 2023. Compared with the December 2020 Eurosystem staff macroeconomic projections, the outlook for economic activity is broadly unchanged.

Overall, the risks surrounding the euro area growth outlook over the medium term have become more balanced, although downside risks remain in the near term. On the one hand, better prospects for global demand, bolstered by the sizeable fiscal stimulus, and the progress in vaccination campaigns are encouraging. On the other hand, the ongoing pandemic, including the spread of virus mutations and their implications for economic and financial conditions continue to be sources of downside risk.

Euro area annual inflation increased sharply to 0.9 percent in January and February 2021, up from -0.3 percent in December. The upswing in headline inflation reflects a number of idiosyncratic factors, such as the end of the temporary VAT rate reduction in Germany, delayed sales periods in some euro area countries, and the impact of the stronger than usual changes in HICP weights for 2021, as well as higher energy price inflation.

On the basis of current oil futures prices, headline inflation is likely to increase in the coming months, but some volatility is expected throughout the year reflecting the changing dynamics of the factors currently pushing inflation up. These factors can be expected to fade out of annual inflation rates early next year.

Underlying price pressures are expected to increase somewhat this year due to current supply constraints and the recovery in domestic demand, although pressures are expected to remain subdued overall, also reflecting low wage pressures and the past appreciation of the euro. Once the impact of the pandemic fades, the unwinding of the high level of slack, supported by accommodative fiscal and monetary policies, will contribute to a gradual increase in inflation over the medium term. Survey-based measures and market-based indicators of longer-term inflation expectations remain at subdued levels, although market-based indicators have continued their gradual increase.

This assessment is broadly reflected in the baseline scenario of the March 2021 ECB staff macroeconomic projections for the euro area, which foresees annual inflation at 1.5 percent in 2021, 1.2 percent in 2022, and 1.4 percent in 2023. Compared with the December 2020 Eurosystem staff macroeconomic projections, the outlook for inflation has been revised up for 2021 and 2022, largely due to temporary factors and higher energy price inflation, while it is unchanged for 2023.

Turning to the monetary analysis, the annual growth rate of broad money (M3) stood at 12.5 percent in January 2021, after 12.4 percent in December and 11.0 percent in November 2020. Strong money growth continued to be supported by the ongoing asset purchases by the Eurosystem, which remain the largest source of money creation. The narrow monetary aggregate M1 has remained the main contributor to broad money growth, consistent with a still heightened preference for liquidity in the money-holding sector and a low opportunity cost of holding the most liquid forms of money.

Developments in loans to the private sector were characterized by somewhat weaker lending to non-financial corporations and resilient lending to households. The monthly lending flow to non-financial corporations continued the moderation observed since the end of the summer. At the same time, the annual growth rate remained broadly unchanged, at 7.0 percent, after 7.1 percent in December, still reflecting the very strong increase in lending in the first half of the year. The annual growth rate of loans to households remained broadly stable at 3.0 percent in January, after 3.1 percent in December, amid a solid positive monthly flow.

Overall, our policy measures, together with the measures adopted by national governments and other European institutions, remain essential to support bank lending conditions and access to financing, in particular for those most affected by the pandemic.

To sum up, a cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirmed that an ample degree of monetary accommodation is necessary to support economic activity and the robust convergence of inflation to levels that are below, but close to, 2 percent over the medium term.

Regarding fiscal policies, an ambitious and coordinated fiscal stance remains critical in view of the sharp contraction in the euro area economy. To this end, support from national fiscal policies should continue given weak demand from firms and households relating to the ongoing pandemic and the associated containment measures. At the same time, fiscal measures taken in response to the pandemic emergency should, as much as possible, remain temporary and targeted in nature to address vulnerabilities effectively and to support a swift recovery. The three safety nets endorsed by the European Council for workers, businesses, and governments provide important funding support.

The Governing Council recognizes the key role of the Next Generation EU package and stresses the importance of it becoming operational without delay. It calls on Member States to ensure a timely ratification of the Own Resources Decision, to finalize their recovery and resilience plans promptly and to deploy the funds for productive public spending, accompanied by productivity-enhancing structural policies. This would allow the Next Generation EU programme to contribute to a faster, stronger, and more uniform recovery and would increase economic resilience and the growth potential of Member States’ economies, thereby supporting the effectiveness of monetary policy in the euro area. Such structural policies are particularly important in addressing long-standing structural and institutional weaknesses and in accelerating the green and digital transitions.

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The only change ECB has done in its Mar monetary policy is an announcement to significantly increase the pace of PEPP buying in Q2-2021 (Apr-Jun) compared to Q1-2021. In Feb’21, ECB purchased PEPP around €59.91B, while APP €20.95B, totaling €80.86B. The average monthly rate of buying of PEPP is around €60B; i.e. €15B/week.

Overall, ECB/Lagarde was non-committal about a ‘significantly higher’ amount of PEPP buying in Q2-2021 from Q1-2021. But ECB may buy around €80-100B PEPP per month in Q2-2021 as per evolving economic/financial conditions (bond yield curve). The ECB may try to match Fed, which is buying QE now at around $120/month. The ECB may buy total QE (PEPP+APP) for around €100-120B/month (equivalent to $120-144B) as per yield curve evolution.

Looking ahead, ECB may also slow down its PEPP buying pace after H1-2021 amid progress of herd immunity (COVID vaccinations) to keep the total envelope of €1.85T till Dec’23 or recalibrate it further as per evolving financial conditions.

In her ECB Presser on 11th Mar, Lagarde was asked why ECB failed to purchase a higher amount in earlier months considering rising bond yields and PEPP flexibility. A visibly upset Lagarde explained the ECB was waiting for Mar's economic projections and GC meeting for the issue. But even then, ECB felt that some increase in bond yields does not result in tightening of overall financial conditions (business and household borrowing costs).

Lagarde was asked whether she can quantify ‘significantly’ higher PEPP buying in Q2-2022, LIKE €25-30B/week from earlier €15B/week, Lagarde said the ECB has no specific number but will increase/adjust the amount of PEPP buying as per evolving financial conditions.

Lagarde was asked what argument she uses to keep the present monetary policy stance if headline HICP inflation (CPI) jumped to +2.00% in the coming days. Lagarde pointed out that due to some transitory factors like lower base effect (2020), temporary relief of German VAT, discounted selling of garments in Italy and France, and higher fuel/energy cost, HICP inflation may scale +2% or even above in 2021, but by 2023, it will come down to around +1.4%, which is far away from ECB’s target of just below +2.00% and also below Dec’19 (pre-COVID) figure of around +1.70%.

On Biden’s CARES Act 3.0 fiscal stimulus for $1.9T, whether ECB accounted it for its economic projections and the spillover impact like inflation on Eurozone economy, Lagarde clarified although ECB has not considered it in its economic projections because of time lag, she thinks that there will be some effect on Eurozone and other economies through trade channel (external demand). Lagarde also called for speedy implementation of the EU’s common fiscal stimulus (NGU). Lagarde also pointed out the current increase in global/EU bond yield is a result of higher U.S. growth and inflation expectations.

Lagarde was asked whether the ECB is trying to control bond yield and doing backdoor YCC by targeting a particular segment of the bond yield curve by its flexible purchase of PEPP. Lagarde denied such ‘misconception’ and said ECB watches all segments of the yield curve from 2-30 years regularly.

On setting up a common EU ‘Bad Bank’ (super ARC) to deal with any huge influx of COVID NPA/NPL, Lagarde said the ECB is closely monitoring any signs of systemic NPA/NPL on EU Banks and also exploring various ways to set up a common ‘Bad Bank’ in this regard.

On recent appreciation of EURUSD (1.20 and above) and its negative impact on inflation outlook (lower imported inflation), Lagarde said although ECB does not target EUR exchange rate, it does monitor the same very carefully as it has an impact on inflation/price outlook and overall economic activity.

Finally, on ECB’s role of any stability & growth pact (SGP) exception extension to deal with unprecedented corona recession and any debt crisis (for fragile EU states), Lagarde said she thinks the general escape clause will be active till at least mid-2022 or till EU economies fully recover (as per last communications by the EU Commission). And Lagarde also thinks that there is a need for structural reform in line with today’s economic circumstances with 1990’ SGP clauses to be made simpler, focusing on improving productivity, investment with adequate fiscal prudence.

Conclusion:

The Eurozone socialistic economy was already under a deflation/stagnant-like scenario even before COVID due to a decade of austerity (lack of adequate and targeted fiscal stimulus) despite never-ending ECB monetary stimulus and ultra-low borrowing costs (almost ZIRP). The ECB/Lagarde is now urging EU states to go for targeted fiscal bazooka and structural reforms to bring out the Eurozone economy from decades of deflation, taking the COVID adversity as a great opportunity.

Although ECB is already doing de facto targeted YCC in various Eurozone member states as per evolving economic scenario, Lagarde said there were no worries about government bond yields and ECB is not targeting any particular levels of bund yields; i.e. it’s not indulged in any kind of YCC. But on 22nd Feb, Lagarde said the ECB is closely monitoring the evolution of longer-term nominal bond yields as banks generally use these bond yields as a reference to price their loans to corporates and households. The ECB will use the PEPP buying (pandemic QE) flexibility as the main tool to ensure overall ultra-accommodative /favorable financial conditions (lower sovereign bond yields, apart from other tools-risk free OIS rate, corporate bond yields, and credit conditions).

Lagarde clearly said that the ECB will ensure COVID monetary vaccine (stimulus/PEPP & other tools) till at least Mar’22, when the EU is expected to achieve widespread herd immunity as the COVID mass-vaccinations may end by Dec’21-Mar’22. The ECB will have to ensure ultra-low borrowing costs (near zero) for not only Germany, but also France, Italy and Spain, and other fragile EU member states to fund COVID fiscal stimulus.

As the EU COVID vaccinations process is running slow due to various issues starting from availability to distribution and quality (safety & efficacy), the EU may not be able to complete its mass vaccinations by Dec’21. It may take H1-2022 to complete the same and widespread herd immunity (COVID) may be visible by Q3-2022. Thus in that scenario, ECB nay continues its PEPP and APP buying till at least Dec’23. The ECB may go for gradual tapering of PEPP from Jan’24 (Q1-2024) or July (Q3-2024) and APP from 2025 onwards. The ECB may never be able to normalize (hike) its interest rate, which is now at zero for almost a decade,

On the other side of the Atlantic, the U.S. is expected to achieve widespread herd immunity (COVID) by Apr-June’22 as mass vaccinations may be completed by Dec’21. Thus the Fed is expected to go for gradual QE tapering from Dec’22 and rate hikes from Dec’23. And there may be significant policy divergence between Fed and ECB.  In its SEP (summary of economic projections), Fed shows substantial progress of achieving its dual mandate by Dec’22 and full achievement by Dec’23, while ECB continues to show a failure to achieve its single mandate (2% core HICP inflation) by even Dec’23 and most probably perpetually.

The Fed has dual mandate-maximum employment and price stability (2% core PCE inflation). On the other hand, ECB has single mandate-only price stability (2% HICP core inflation). And both Fed and ECB are changing their mandate goal post as per evolving economic scenario to ensuring the lowest borrowing costs for not only Main Street (business and household), but also for the respective governments to fund the deluge of COVID fiscal stimulus at least till 2023-25.

The government is the biggest and safest borrower. The cost of borrowing for EU member states is much lower than the U.S. Before COVID, France’s debt interest/revenue was around 3-4% against U.S. 7-8%. But despite that due to stringent EU austerity (fiscal discipline) policy and lack of common fiscal authority, especially after the 2012-13 debt crisis, which follows after2008-10 GFC, there was no fiscal bazooka. This may be the main reason behind the EU’s subdued economic growth and deflation-like scenario.

Bottom line:

The ECB was never able to stimulate the economy even by its ultra-accommodative monetary policy due to lack of adequate fiscal stimulus. Thus ECB miserably failed to achieve its inflation target and was never able to hike after the 2008 GFC. The ECB’s current policy of back-door YCC through targeted PEPP buying may also accelerate ‘Japanification’ of the Eurozone economy and EUR like Japanese Yen becomes more like funding rather than growth currency.

Fast forward, now ECB is urging EU member states to take necessary steps for implementation of the EU Next Generation fiscal/infra stimulus immediately, while the EU is still divided on the same. This lack of common fiscal authority despite a common currency (EUR) and the central bank may be the main reason behind EU inequality and fragmentation. The only solution lies in perhaps the formation of the United States of Europe-USE (like the United States of America-USA) rather than staying only as a common free trading zone for the advantage of a few export-heavy countries like Germany.

Technical outlook: EURUSD

Technically, whatever may be the narrative, EURUSD has to sustain over 1.16900 for some rebound; otherwise, expect more correction.

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