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ECB pushes back on market expectations

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2 Dec 2021

The European Central Bank’s decision to maintain its bond-buying programme has left investors unconvinced, finds Andrew Holt.

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The European Central Bank’s decision to maintain its bond-buying programme has left investors unconvinced, finds Andrew Holt.

ECB

The European Central Bank’s decision to maintain its bond-buying programme has left investors unconvinced, finds Andrew Holt.

The European Central Bank’s (ECB) decision to keep its big bond-buying programme running has raised some eyebrows in the investor community.

The bank announced at the end of October that its €1.85trn (£1.5trn) pandemic emergency purchase programme would continue, albeit at “a moderately lower pace” than the €80bn (£68.6bn)-a-month level it ran at until September.

Maintaining the position in November, Lagarde said: “We must not rush into a premature tightening when faced with passing or supply-driven inflation shocks,” a strong indication that the ECB is to maintain a substantial stimulus. 

Aligned to this is the ECB’s position on interest rates, inflation and the wider European economic picture. It seems that the financial markets have started to price in an interest rate hike in 2022 – a position that directly conflicts with ECB president Christine Lagarde’s outlook.

Among her predictions for the year ahead, Lagarde said: “We foresee inflation rising further in the near term but then declining in the course of next year.”

Unconvinced market

Jon Day, fixed income portfolio manager at Newton Investment Management, says the market is not convinced about the decision. “The ECB are determined they will look through this inflation, but the market remains to be convinced – bonds sold off and the euro rallied post the meeting.

“Eurozone yields remain very low by global standards reflecting the ECB’s ultra-loose monetary policy: they still remain poor value versus markets that are pricing in rate normalisation.”

Much of the ECB’s move comes from a transitory view of inflation. The ECB foresees inflation at 2.2% in 2021, 1.7% in 2022 and 1.5% in 2023 – thus below its 2% target. The bank will be updating those forecasts in early December.

Day adds: “The ECB attempted to push back market expectations at their meeting, but they are still firmly of the view inflation is transitory and will be falling back towards target next year, but even the ECB admitted inflation will be around for longer than they expected.”

Lagarde did indeed note: “Rising energy prices, the recovery in demand and supply bottlenecks are currently pushing up inflation. While inflation will take longer to decline than previously expected, we expect these factors to ease in the course of next year. We continue to foresee inflation in the medium term remaining below our 2% targets.”

Tight environment

Day noted how Europe is bearing the brunt of the rise in energy prices and how this will contribute to the inflationary picture. “With a lack of supply, tightening environmental rules and the winter still ahead, it’s difficult to see the situation imminently resolving itself, inflationary pressures will be around for a while yet.”

The energy inflation rate is now an extraordinary 23.5% and consumer gas prices have yet to be fully incorporated into these numbers because of contract adjustments not all happening immediately.

In Spain, higher energy prices have driven October inflation to a 37-year high of 5.5% and German prices rose to 4.6% in the same month from 4.1% in September.

Underlining how inflationary pressures are rising in Europe, the selling price expectations of EU companies rose to a record high in October, according to the European Commission, while consumer price expectations rose to their highest level since November 1992.

Lagarde also rejected fears of “stagflation” pointing instead to the euro area economy recovering strongly, even if it had lost some momentum due to supply chain issues and a surge in energy prices.

The ECB’s position does contrast with other central banks such as the Bank of England and the US Federal Reserve, which have both indicated moves towards tightening policy.

Correct call?

A great deal of the ECB’s policy hinges on its assessment of inflation. “The ECB does not really want to end up in a situation in which it has to admit that it was wrong on inflation being transitory and then having to react swiftly and with full force,” noted one study of the situation.

Many market observers are nevertheless expecting Lagarde and the ECB to announce a formal tapering in December. The central bank’s Covid-19 stimulus program is due to end in March of next year, which will take the lid off the situation one way or another. Understandably, many analysts are expecting a re-adjustment in the bank’s stimulus ahead of that date.

Therefore, key questions at the December ECB meeting will be how many asset purchases are needed to bring Eurozone inflation back to a target level and is it the monthly net purchases or the total size of the ECB’s balance sheet which matters most.

Investors will be watching keenly to see the ECB’s next move.

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