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ECB weighs slower bond purchases as economy rebounds

European Central Bank updates

“Go big or go home,” is how Christine Lagarde likes to describe the European Central Bank’s response to the economic carnage caused by the pandemic. 

Now that Europe’s economy is rebounding from the Covid-19 crisis, the challenge facing the ECB president is how the central bank should unwind its massive monetary stimulus without cutting short the recovery or spooking the bond market, especially for southern European borrowers.

The delicate task has intensified divisions within the ECB and, on Thursday, economists expect to get a first glimpse of how it might wind down its €1.85tn pandemic emergency purchase programme (PEPP), its flagship bond-buying policy to shield financial markets from the crisis.

While investors expect Lagarde to announce a dialling down of its PEPP purchases, economists say the bigger question confronting the central bank is inflation. This has risen to a decade high in large part because of shortages of goods as well as resurgent demand.

“From a macroeconomic perspective, whether they go from €80bn of PEPP purchases a month to €70bn or €60bn doesn’t really matter,” said Silvia Ardagna, chief European economist at Barclays. “The key questions are what happens to asset purchases after PEPP ends . . . and what they expect on inflation.”

The possibility of rampant inflation is fuelling tensions between conservative “hawks” on the ECB governing council and the more numerous “doves”, who want to keep a sizeable stimulus to support recovery.

For the past 18 months, hawks such as Jens Weidmann of Germany, Klaas Knot of the Netherlands, and Robert Holzmann of Austria have stoically supported the ECB’s crisis response. 

But they have become more vocal since eurozone gross domestic product expanded by 2 per cent in the second quarter, overtaking China and the US for the first time since the pandemic hit. Inflation also rose to a decade-high level of 3 per cent in August, well above the ECB’s target of 2 per cent.

Hawks worry that inflation will continue to outstrip expectations, fuelled by supply chain bottlenecks, resurgent demand and households spending excess savings built up during the pandemic. They fear that if the ECB is too slow to respond it will have to tighten policy suddenly to prevent economic overheating.

“The risks are tilted to the upside right now,” Bundesbank president Weidmann warned in a speech last week. “If these transitory factors lead to higher inflation expectations and accelerated wage growth, the rate of inflation could rise perceptibly over the longer term.”

The ECB will publish updated forecasts on Thursday. Most analysts expect it to raise its predictions for inflation this year and coming years, even though they also expect inflation to fall sharply next year and remain below the ECB’s target throughout 2023.

Katharina Utermöhl, senior economist at Allianz, said that the recent surge in eurozone inflation looked more modest if averaged over two years, which reduces it to below 1.5 per cent. She added: “Reflation is not inflation — mind the rollercoaster base effects.”

Economists add that there are few signs yet that inflation is feeding into higher wages, although Germany’s Verdi union recently asked for a 5 per cent pay rise for 1.1m public sector workers. Bars and restaurants in Paris and Berlin have also boosted pay to fill vacancies. 

“Right now there is a disconnect between wage data, which remains flat, and the anecdotal evidence of some higher wage demands and pockets of staff shortages,” said Jacob Nell, head of European economics at Morgan Stanley.

The debate over the trajectory of inflation will be crucial in deciding the other big question hanging over the ECB: how much stimulus to pump into the economy by buying bonds when PEPP finishes next year.

While other major central banks, such as the US Federal Reserve and the Bank of England, are preparing to “taper” their asset purchases to reduce them to zero, the ECB will continue buying bonds with its traditional purchase programme. This is still running at €20bn a month and is expected to be doubled or tripled when PEPP ends.

ECB holdings as % of eligible universe

The size of the boost is unlikely to be decided before December, but a more controversial question is how much of the extra flexibility of PEPP will be transferred to the ECB’s ongoing asset purchase programme.

This flexibility would allow the ECB to exceed its self-imposed limit on owning more than a third of any country’s eligible bonds, something it is close to doing already in Germany and the Netherlands.

So far, governments have been able to vastly increase their debt levels without worrying too much about the cost. But if the ECB’s firepower to buy more bonds is restricted, investor anxiety could push yields sharply higher.

Meanwhile, hawks worry that raising the limits on sovereign bond purchases will open up the ECB to accusations of breaching the EU’s ban on monetary financing of governments, a charge partly upheld by Germany’s constitutional court last year.

“This is the key discussion they are having: not whether to beef up their ongoing asset purchase programme to follow PEPP but how much flexibility there will be,” said Spyros Andreopoulos, senior European economist at BNP Paribas.


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