Updates from the European Central Bank
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“Go big or go home” is how Christine Lagarde likes to describe the reaction of the European Central Bank to the economic slaughter caused by the pandemic.
Now that Europe’s economy is recovering from the Covid-19 crisis, the challenge for the ECB President is how the central bank should run its massive monetary stimulus without curtailing the recovery or scaring the bond market, especially for southern European borrowers.
The delicate task has exacerbated the divisions within the ECB, and economists expect a first glimpse on Thursday of how they could run their € 1.85 trillion emergency pandemic purchase program (PEPP), their flagship bond buying policy to prevent the financial markets from getting ahead to protect the crisis.
While investors expect Lagarde to announce a decline in its PEPP purchases, economists say the central bank’s bigger question is inflation. This has risen to a decade, in large part due to shortages of goods and resurgent demand.
“From a macroeconomic point of view, it doesn’t matter whether they go from 80 billion euros in PEPP purchases per month to 70 billion euros or 60 billion euros,” said Silvia Ardagna, chief economist for Europe at Barclays. “The key questions are what happens to asset purchases after the end of PEPP. . . and what they expect from inflation. “
The possibility of rampant inflation is fueling tensions between conservative “hawks” in the Governing Council and the more numerous “doves” who want to maintain a sizeable incentive to support the recovery.
Over the past 18 months, falcons such as Jens Weidmann from Germany, Klaas Knot from the Netherlands and Robert Holzmann from Austria have stoically supported the ECB’s response to the crisis.
But they’ve gotten louder since euro area gross domestic product rose 2 percent in the second quarter, overtaking China and the U.S. for the first time since the pandemic broke out. Inflation also rose in August, at 3 percent, to a level that has been high for decades and was thus well above the ECB’s target of 2 percent.
Hawks fear inflation will continue to exceed expectations, fueled by supply chain bottlenecks, resurgent demand and households spending excess savings during the pandemic. They fear that if the ECB reacts too slowly, it will suddenly have to tighten its policy to prevent the economy from overheating.
“The risks are currently tilted upwards,” warned Bundesbank President Weidmann in a speech last week. “If these temporary factors lead to higher inflation expectations and accelerated wage growth, the inflation rate could rise noticeably in the longer term.”
The ECB will publish updated forecasts on Thursday. Most analysts expect it to raise its inflation projections for this year and beyond, although they also expect inflation to drop sharply next year and stay below the ECB’s target through 2023.
Katharina Utermöhl, senior economist at Allianz, said the recent rise in inflation in the eurozone looked more modest on average over two years, reducing it to below 1.5 percent. She added, “Reflation is not inflation – think of the roller coaster base effects.”
Economists add that there is still little evidence that inflation is leading to higher wages, although the German union Verdi recently called for a 5 percent pay increase for 1.1 million public sector workers. Bars and restaurants in Paris and Berlin have also increased their pay to fill vacancies.
“Right now there is a discrepancy between the wage data, which is unchanged, and the anecdotal evidence of some higher wage claims and staff shortages,” said Jacob Nell, director of European economics at Morgan Stanley.
The inflationary debate will be crucial in deciding the other big question hanging over the ECB: how much stimulus can be pumped into the economy by buying bonds when the PEPP ends next year.
As other major central banks such as the Federal Reserve and the Bank of England prepare to reduce their bond purchases to zero, the ECB will continue to buy bonds with its traditional purchase program. This still amounts to € 20 billion per month and is expected to double or triple when PEPP ends.
The size of the boost is unlikely to be decided before December, but a more controversial question is how much of PEPP’s added flexibility will carry over to the ECB’s ongoing asset purchase program.
This flexibility would allow the ECB to exceed its self-imposed limit for owning more than a third of the eligible bonds of all countries, which is already close in Germany and the Netherlands.
So far, governments have been able to massively increase their debt without worrying too much about the costs. But if the firepower of the ECB to buy more bonds is curtailed, investor fear could drive yields soaring.
Meanwhile, Falken fear that raising the caps on government bond purchases will trigger the ECB to suspect violations of the EU’s ban on monetary government funding, an indictment that was partially upheld by the German Constitutional Court last year.
“This is the key discussion they are having: not whether to step up their ongoing asset purchase program to follow PEPP, but how much flexibility there will be,” said Spyros Andreopoulos, Senior European Economist at BNP Paribas.