The Governing Council of the European Central Bank is scheduled to meet again on Thursday, October 28.
With important decisions on the future path of the ECB’s bond purchase programs looming at its subsequent, December meeting, the October meeting will serve mainly, in the words of one official, to “gauge the mood” around the table on inflation.
Our understanding is that these deliberations are likely to lead to a change in the wording of the language around inflation in the ECB’s communications. To what exactly, we are not sure, but the upside directionality of the inflation deliberations, and further upside forecast revisions come December, we believe are all but certain.
The leadership at the ECB Board, led by President Christine Lagarde, Executive Board Member Isabel Schnabel, and especially Chief Economist Philip Lane, has gone out of its way to repeatedly make the case that the current intense inflationary pressures are transitory, a result largely of supply chain disruptions. To be precise, President Lagarde has carefully caveated that they are “largely” transitory, but these pressures, of course, have been higher and will be longer lasting than initially expected.
The ECB will nevertheless continue to characterize these inflationary pressures as part and parcel of a “bumpy transition” out of the pandemic for which the central bank’s main role is to help steer through volatility, a description of the central bank’s role by former IMF economist Ken Rogoff at a recent symposium that seems to have especially resonated with some ECB officials.
As to those navigation skills, Lane appears to have raised some eyebrows around the Council in his comments last Monday that even if union wage round negotiations this year result in significant wage hikes to compensate for inflation, why that too is also transitory and will not feed into structural pressures.
And Schnabel, for her part, has come under increasing fire in the German press for doubling down so hard on the transitory narrative, and when she acknowledged that these looked to be longer lasting than initially thought, was then criticized for backtracking.
But perhaps most to the point, the official line at the ECB, stressed often by Banque de France Governor Francois Villeroy de Galhau, that in the medium-term Eurozone inflation is definitively expected to fall below 2% again, appears also to no longer be so convincingly held across the system.
It was perhaps with all that in mind that the consensus oriented and more politically sensitive Lagarde stated this weekend that the ECB will indeed pay close attention to wage developments and inflation expectations to ensure that inflation expectations are anchored at 2%.
That all will feed into deliberations next week over inflation, communications, and the calibration in December, and eventual wind down, of the ECB’s bond purchase programs.
Upward Revisions to Forecasts
Over the last two quarterly forecast revision rounds, the ECB raised its inflation forecasts dramatically from 1.5% in March to 2.2% in September for 2021, and more significantly from a policy perspective from 1.2% to 1.7% for 2022, even while nudging its 2023 forecast from 1.4% to 1.5%.
The staff work for the next quarterly forecast revisions has not yet begun in earnest, but it appears that further revisions upwards of somewhere in the magnitude of 0.2% for next year, putting inflation at around 1.8%-1.9%, are likely again in December, which will also debut the 2024 forecasts. There will likely be upwards revisions to the 2021 and 2023 inflation forecasts as well.
That will necessitate changes in advance to how inflation pressures, these forecasts, and continued policy accommodation are characterized.
The hawks – and we hesitate to even use that term at the ultra-accommodative ECB — will note that the Governing Council agreed in its policy review this summer that it would incorporate the impact of Owner-Occupied Housing (OOH) into its decision making. As you will recall from previous SGH reports, this is estimated to add around 0.2% to inflation, even if Eurostat has not yet formally incorporated OOH into its inflation measures.
And so, miracle of miracles, come December the ECB it now appears will show a forecast by that measure effectively at or slightly above its 2% inflation target for next year. And that will open an interesting debate over overshoots, and for how long and by what magnitude the Governing Council will fuel, and let these inflationary pressures run.
The Great Inflation Debate
As a reminder, the ECB formalized in its policy review a tolerance for inflation to run moderately above its 2% (symmetrical) target. An exceptionally high 2021 (even if supply related), and a 2022 by some measures now potentially at or even a hair above target, could be characterized as that.
The doves will emphasize the historic, powerful structural disinflationary forces in the Eurozone, and concerns over the sustainability of inflation. But legacy issues aside, as opposed to their colleagues at the Federal Reserve, the ECB has stopped short of adopting a deliberate average inflation targeting regime to make up for past undershoots.
In the near-term they will also push back on the durability and pass-through risks of higher energy prices from headline into core CPI. While wholesale energy prices, especially natural gas, have truly exploded, by as much as 300% in some cases, this they note has been largely absorbed along the distribution chain and by governments.
In Germany, for example, our understanding is that around 90-95% of households are under fixed contracts – the pain has been more severe in southern states like Spain. And while it may be poor solace to the population, on a statistical level the retail impact of the natural gas squeeze, while still significant, has been roughly one tenth of the wholesale price explosion, with energy then making up around 10% of the inflation basket.
We will reserve judgement on the merits of that argument.
The Policy Normalization Path
But for all the fits and starts, the one thing that is increasingly clear on the policy front is that the gradual policy normalization process is now well underway for the ECB, with an emphasis always on the “gradual.”
In practice, the shifting inflation data means rate hikes could come far sooner than the 2024 hikes that were initially implied after the ECB’s new framework guidance. But gradual is the word, and as one centrist at the ECB notes, even the most hawkish ECB members would push back on market expectations now for a hike as soon as in late 2022 – at least as things currently stand.
Where these higher inflation forecasts will matter more immediately will be in calibrating the ECB’s asset purchase programs at its December meeting for Q1 2022, and through the rest of the year. As a reminder rates, and not the non-conventional asset purchases, are the ECB’s preferred means of longer term, continued accommodation.
In September, when the ECB decided to step down its Pandemic Emergency Purchase Program (PEPP) from 80 billion to roughly 60 billion euros per month, President Lagarde went out of her way to stress the adjustment was not a “taper,” meaning it was not on a predefined path.
But as we said then, and as early as in June, barring some significant economic or market dislocation, we expect the ECB will step down its PEPP purchases by a similar amount to 40 billion euros per month again come January as it looks to wind down that emergency program as planned at the end of March 2022 (see SGH 6/28/21, “ECB: A Glidepath for Bond Purchases”). With inflation sticking now for a while, even if “largely transitory,” that second step-down seems that much more certain, and we expect there may even be an argument made in the Governing Council for cutting Q1 purchases by more, even if it may not win the day.
Then in April, when the PEPP runs off we, and now consensus, have been expecting the existing and concurrently running 20 billion euro per month Asset Purchase Program to be topped off to avoid a cliff effect from a presumably combined 60 billion at that point all the way to the 20 billion euro per month pace.
Two major decision steps ahead, the exact number by which that 20 billion is bumped up, or if it is even at all, is still far too early to hazard. It could still be by the 20 billion which we laid out in June, for a total purchase program then of 40 billion euros per month, in essence splitting the difference and keeping that same quarterly pace in reducing bond purchases.
But with inflation panning out as it has, we think the risks are that the ECB could do a more rapid unwind now than that, either for Q1, Q2, or both, depending on market conditions. If not accelerated in December, for example, the April bump could be just by 10 billion, and even if the ECB settles into a 40 billion euro per month pace come April, as we had originally expected, we now believe the strong likelihood – we would call it a certainty — is that a 480 billion/year pace will not be carried through 2022, which some market participants seem to expect, but will get notched down again.
Flexibility, and the Capital Key
With no drama left around the expiration of the PEPP program, some Council members, in particular Governor Villeroy, have already turned their focus beyond PEPP, and to enhancing flexibility around the ECB’s Asset Purchase Program.
The flexibility Villeroy is referring to is enshrining the ability of the emergency PEPP program to purchase bonds across jurisdictions without having to adhere to the ECB’s self-imposed “Capital Key” guidelines, even if on a “contingency” basis. Our understanding is that this does not mean that the ECB is likely, even if it is considered, to lift its self-imposed 33% cap on sovereign bond purchases as well.
That cap may have been an important consideration in years past, including back in 2018 when the ECB ended its APP program, only to be re-started a year later again. But massive issuance by sovereign states through the Covid pandemic has made hitting those limits in effect moot, at least across the major Eurozone member states. New and increased issuance by supranational entities, which carry a more generous 50% ECB ownership limit, including by the Next Generation EU fund, has and will also help alleviate any limit concerns.
Some smaller states with little debt, like Estonia, Luxembourg, Slovakia, and Malta have however basically hit their 33% limits already. But officials say it is hard to argue that these need additional or targeted interventions by the ECB as it manages the broader markets.
Regardless, the ECB has no need at least yet to revise these old 33% “CAC” (Collective Action Clause) bond purchase limits, which carry with them after numerous legal challenges the hard-earned and important imprimatur of the European Court of Justice as well, because the direction of travel since September has been to gradually remove, not add, accommodation.
Indeed, our “Glidepath” report, which at the time may have seemed hawkish to market participants expecting the ECB might even add to its PEPP program, is now a baseline consensus, with the proverbial risks increasingly tilted we believe to a faster deceleration of bond purchases than that now come 2022.