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The ECB blinked

I concluded my article for Munix in the week of February 22nd with the words “If the reflation trade continues to worry central bankers enough, then some like the ECB may be forced to follow in the footsteps of the Bank of Japan and formally adopt yield curve control”. Today we saw a small step along that path by European policy makers.

One of the major trends in financial markets during 2021 has been the inexorable rise in government bond yields. In turn this has triggered such changes as a vicious rotation from ‘growth’ to ‘value’, from technology to banking, within the stock market, or a rise in the US dollar versus other major currencies.

As vaccination programmes begin to have an effect, and in the light of Biden’s massive $1.9 trillion spending package finally passing through Congress, economists have begun to re-assess what this means for growth and inflation in the coming year, and the consequences for policy makers. For example, the OECD now expects the world economy to reach pre-pandemic levels of output by the middle of this year, six months earlier than it expected in its previous forecasts made last November. Consequently, the money markets – rightly or wrongly – are pricing in a move higher in US interest rates by late 2002 rather than the following year.

Concerns have grown about the danger of higher borrowing costs rippling through the real economy. Hence, some central banks have responded by stepping up their purchases, such as the Reserve Bank of Australia holding down shorter dated bond yields.

What is the situation in Europe? Initially the ECB tried to reason with the markets. In recent weeks there were several dovish speeches pushing back against market momentum. For example, executive board member Fabio Panetta warned “we are already seeing undesirable contagion from rising US yields …. that is inconsistent with our domestic outlook and inimical to our recovery”. The market’s effective tightening of financial conditions since December, when the ECB last tweaked its stance, “is unwelcome and must be resisted”, he added.

This week’s European Central Bank meeting gave us a good opportunity to assess how policy makers see the damage to economic growth, pitting a rather slow vaccination rollout against an improvement in global trade, measuring the impact of loose fiscal policies across the EMU against the latest senior loan officer’s survey which reported that credit standards in the euro area have tightened back to 2012 levels.

Despite all these factors, there was no change in the ECB’s growth forecasts; it expects GDP to expand by 4% in 2021 and 4.1% in 2022, easing back towards trend at 2.1% in 2023. Some temporary factors will affect inflation this year but these are expected to die away. Hence the Bank sees CPI rising by 1.5% in 2021, 1.2% in 2022 and 1.4% in 2023 – still well below its long run target.

Nevertheless, there was clearly sufficient concern amongst a majority of ECB members about the potential impact of higher borrowing costs on the economy that a decision was reached to slow or cap the rise in bond yields. The Bank surprised the markets by announcing that it would ramp up the pace of its purchases of eurozone debt, in particular that purchases will be made at a significantly higher pace over the next three months than earlier this year. However, this change is not as significant as might appear at face value. The total amount to be purchased will

not alter, the bond buying programme remains €1.85 trillion. For a more meaningful impact, the size of the envelope will have to be increased. Analysts close to the ECB argue that today’s decision looks like a compromise of a split Governing Council.

Do deliberations of the ECB matter for the Bank of England? Certainly. In economic terms, a slower expansion in Europe than other parts of the world will ripple through to the UK economy,

while an appreciation of the pound against the euro will restrain UK inflation to some extent. In policy terms, two major central banks have altered their bond buying programmes. Will the markets put pressure on the MPC to follow suit?

Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial ma;ers and should not be considered as financial advice in any form.

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