ECB poised to clarify tapering of PEPP purchases

Analysts agree central bank views higher inflation as transitory and will maintain rate of purchases
ECB + bridge

The European Central Bank is set to clarify its medium-term plans for its main asset purchase after its policy meeting on June 10.

Analysts agree the central bank considers recent higher inflation a temporary phenomenon. In May, the harmonised index of consumer prices (HICP) rose above the ECB’s target, hitting 2%, according to early estimates by Eurostat. This would be the first time inflation reached that level since October 2018. Nonetheless, this is not expected to trigger a reduction in asset purchases.

However, the governing council will have to provide clarity about its plans for the Pandemic Emergency Purchase Programme (PEPP). In March, ECB president Christine Lagarde announced an increase in the rate of purchases from the first quarter of 2021 in a bid to address higher sovereign bond yields. As a result, the central bank has been purchasing bonds at a monthly rate of €80 billion ($97 billion) in April and May, up from €53 billion in January and €60 billion in February.

But this increase also implied a quarterly review of purchases that observers expect the ECB will update this week.

“The governing council is facing a delicate communication exercise ahead of its June 10 meeting as the hawks will be pushing for a slowdown in the pace of PEPP purchases while the doves will try to avoid any talk of tapering,” says Frederik Ducrozet, strategist at Pictet Wealth Management.

In his view, this is the result of two communication mistakes the central bank made in recent months. “First, no one really knows what a ‘holistic and multifaceted approach to financing conditions’ means in practice. The ECB’s reaction function lacks clarity,” says Ducrozet. “Second, the commitment to a quarterly review of the pace of PEPP purchases de facto reduces the programme’s flexibility.”

Over the last few weeks, leading governing council members have argued against reducing the central bank’s stimulus. “A premature withdrawal of policy support would risk suffocating the recovery before it becomes self-sustained,” said executive board member Fabio Panetta.

Similarly, in May, Banque de France governor François Villeroy de Galhau insisted net purchases under the PEPP are scheduled to continue until March 2022. “Any suggestion of a reduction in our purchases before then – what is sometimes called by the technical term tapering or phasing-out – is purely speculative,” he said.

Temporary inflation, no taper?

The May rise in inflation is mainly the result of higher energy prices. Eurostat estimates these to have risen by 13.1%, up from 10.4% in April.

This year-on-year increase reflects the artificially low levels of inflation during the first lockdowns to contain the Covid-19 pandemic in the second quarter of 2020. Better economic forecasts have helped push oil prices up by 14% since the ECB’s March policy meeting. Nonetheless, this trend will not necessarily mean higher inflation.

For instance, higher oil prices “will weigh on consumption prospects,” says Ducrozet. “Meanwhile, the circa 30 basis point rise in bond yields and the 0.7% appreciation in the trade-weighted euro since March will weigh on growth and core inflation projections.”

As a result, he expects Lagarde “to push for a compromise while postponing any hard decision about the phasing-out of the PEPP to the September meeting, when the ECB is scheduled to publish the outcome of its strategy review”.

However, the rapid decrease in contagion and much faster vaccination across the region is allowing the reopening of bars and restaurants, creating more opportunities to spend.

“Along with buoyant global demand, this will let GDP grow at a breakneck pace over the summer. This resurgence of growth will trigger a cyclical bout of reflation that will be amplified by supply bottlenecks and energy price base effects,” says Oliver Rakau, Germany economist with Oxford Economics.

Reinforcing this point, Jack Allen-Reynolds, senior Europe economist with Capital Economics, points to recovering tourism, clothing prices and base effects derived from last year’s cut in Germany’s VAT.  

“The ECB is also very likely to revise up its near-term forecasts next week,” says Allen-Reynolds.

In its previous forecasts in March, the ECB expected HICP inflation to rebound from 0.3% in 2020 to 1.5% in 2021. Nonetheless, it forecast it peaking at 2% in the last quarter of 2021, before dropping to 1.2% in 2022, modestly increasing to 1.4% in 2023.

Capital Economics shares the mid-term perspective of ECB economists. “Crucially, while we suspect that inflation will be higher than many expect this year, we think it will surprise on the downside in 2022 and 2023,” Allen-Reynolds says. “This is partly because we expect the economic recovery to take some time, leaving some spare capacity in the economy.”

On the inflation front, Rakau expects the ECB to mainly acknowledge higher energy prices’ effect on headline inflation. Otherwise it will “stick to its view that the price spike in H2 2021 will remain transitory. Hence, we think that the ECB will revise its medium-term inflation view modestly at most, especially as regards core inflation, where there is little sign of a pick-up.”

Despite the recent inflation uptick, it appears to be a widespread consensus among policy-makers that the fiscal stimulus implemented in the eurozone, and the recovery, will not be enough to fully offset the fundamentals that kept inflation well below target since 2013.

“Even the hawks seem to agree that the inflation outlook still warrants loose monetary policy well after the pandemic phase, but the hawks will likely object against the PEPP instrument specifically,” says Elwin de Groot, head of macro strategy at Rabobank. “It is therefore getting increasingly likely that the ECB will decide to phase out the PEPP to mark the end of the pandemic.”

In his view, from March 2022, the ECB will abandon net purchases under the PEPP. Instead, the governing council will probably increase the €20 billion a month purchases under the Asset Purchase Programme.

But over the coming months that will remain off the table. “The whole concept underlying the PEPP is inconsistent with the idea that there will be a mechanical tapering of asset purchases,” said executive board member Isabel Schnabel in an interview on May 28.

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