European Central Bank policymakers are reassessing the extent of their commitment to extra stimulus, reflecting rising doubts about how quickly inflation is expected to fall as the Omicron coronavirus variant fuels worries of further price rises.
A trio of recent events has sown doubts in the minds of some rate-setters at the ECB, which has been forecasting for months that inflation would fall back below its target and justify the continuation of vast stimulus policies.
The first was the surge in eurozone inflation to 4.9 per cent in November, well above the ECB’s 2 per cent target and a record since the euro was created two decades ago. This was followed by the emergence of a new coronavirus variant, which threatens to prolong the pandemic and with it the supply chain bottlenecks that have pushed up prices.
Then late last week, the US Federal Reserve said it would accelerate the ending of its bond-buying programme to tackle inflation, putting pressure on the ECB to rein in its own asset purchase plans.
Ahead of the ECB meeting next week, analysts worry that together they increase the chance of a “hawkish” shift by rate-setters to withdraw stimulus earlier than investors have been expecting, raising the odds of a sell-off in the eurozone government bond markets.
“On Omicron, it’s clear that it will keep inflation up for longer because the disruption of supply chains will last longer,” said an ECB governing council member.
“The pandemic has changed the structure of the economy, with more homeworking, a higher carbon price and a shift away from globalisation,” the council member continued. “Over the medium-term, inflation could be higher than our target and then we would have to act.”
The central bank is expected to announce at its meeting next Thursday that it will stop new bond purchases in March under the €1.85tn emergency programme launched in response to the pandemic. But ECB policymakers could also delay a further decision on how many more bonds they would buy in 2022 until early next year.
“I would be very uncomfortable committing to anything beyond the end of the second quarter of next year,” said a second council member. “Markets are just going to have to live with that.”
A third council member said a delay to its decision on future bond purchases was possible “depending on the pandemic and new data in the next two weeks”.
The ECB has bought more than €2.1tn of bonds over the past two years, soaking up more than the total net issuance of eurozone governments in an effort to keep borrowing costs low.
But analysts at UniCredit calculated that this could change next year, even though eurozone governments are expected to raise less debt, unless the central bank doubles the amount of bonds it buys under an earlier asset purchase programme to €40bn a month from April until the end of 2022.
By continuing large-scale bond-buying next year, the ECB would be a significant outlier compared with other central banks that planned to halt asset purchases soon, including the Fed and Bank of England. The Bank of Canada has already done so.
Consensus is growing on the ECB council that there is little extra benefit from increasing the monthly flow of asset purchases in terms of boosting inflation, according to two of its members. “There is no point expanding the asset purchase programme after March,” said one.
Analysts think the ECB could commit to an extra “envelope” of bond purchases after March next year. But they said its decision was complicated by the fact that it was almost certain to raise its 2022 inflation forecast to well above 2 per cent next week, making it harder to justify a commitment to keep buying large amounts of bonds.
“Upside surprises have been sizeable on inflation and the revision to the ECB’s 2022 forecasts will be one of the highest ever in the history of these forecasts,” said Frederik Ducrozet, strategist at Pictet Wealth Management. He expects the central bank to raise its forecast for inflation next year from 1.7 per cent to 2.7 per cent.
Reinhard Cluse, economist at UBS said: “The upcoming meeting is potentially one of the most difficult ones for the governing council in recent times, given the contrasting pressures on its inflation mandate. Government bonds in the periphery countries of southern Europe “appear vulnerable to a shift in ECB communication”, he added.
Christine Lagarde, ECB president, said last week that the bank was “very unlikely” to raise its deposit rate from minus 0.5 per cent next year, because it still expected inflation to fall below its target by 2023.
Despite Lagarde’s comments, markets are still pricing in a 0.1 per cent ECB rate increase at the end of next year, though a month earlier investors were betting on two rate rises in 2022.
“They’ve laboured that message so much that it’s finally getting through,” said Antoine Bouvet, rates strategist at ING. “Part of the reason it’s been so difficult is because of the Fed, whose influence leaks through into eurozone rate pricing.”
The ECB has committed not to raise rates until it stops asset purchases, which economists say is unlikely before 2023, even if it keeps reinvesting the proceeds of maturing bonds long after that. “They could conclude asset purchases by mid-2023 and then it is feasible to see a first rate rise in late 2023,” said Katharina Utermöhl, economist at Allianz.