FLASH BRIEF
ECB December meeting preview: The push for a new PEPP

By Jeremy Hawkins, Senior European Economist
December 13, 2021

Thursday’s ECB announcement will be dissected not so much for what it has to say about what happens to monetary policy now, but rather for clues about the central bank’s plans for next year. For the time being, policy is on hold and there is minimal chance of any immediate move on QE and even less likelihood of a change in interest rates. However, with inflation already well above target and still rising, the Governing Council’s hawks are circling and there will be increasing pressure from some quarters to signal a shift to less monetary accommodation next year. To this end, updated economic forecasts will be instrumental in shaping how investors perceive the medium-term prospects for policy.

The main focus will be the €1.85 trillion pandemic emergency purchase programme (PEPP), introduced in March 2020 and specifically aimed at combatting the effects of Covid. Monthly purchases under the PEPP were cut to just short of €70 billion in October and November, in line with the ECB’s September decision to buy assets at a “moderately lower pace than in the previous two quarters (then about €80 billion/month).” Currently the PEPP still has around €300 billion available for future purchases but the ECB is not committed to full utilisation unless conditions so dictate. At least as importantly, the PEPP is slated to end in March next year and some countries, notably Germany and the Netherlands, will be keen to ensure that this remains the case.

However, unless offset elsewhere, terminating the PEPP in 2022 would put a large hole in the overall QE programme and that could threaten the maintenance of favourable financing conditions, the ECB’s key goal. This could be filled by expanding the longstanding asset purchase programme (APP) but with a fixed (currently €20 billion) monthly purchase target, it lacks the PEPP’s flexibility and it is also open-ended. Such a move would not sit well with the hawks and it would also blur the distinction between economically-driven QE (APP) and pandemic-driven purchases (PEPP). Consequently, more probable is a new, almost certainly smaller, version of the PEPP. This would again be free of any fixed buying targets and operate without any commitment to full utilisation. (Note that even when the PEPP ends, the ECB will continue to reinvest the principal payments from its maturing securities until at least the end of 2023.)

In terms of interest rates, ECB President Lagarde last week reiterated her view that a hike in 2022 was unlikely but promised to act should inflation stay higher for longer than expected. In practice, the central bank’s projections have been well short of the mark and last December’s anticipated 1.5 percent peak this quarter had been revised up to fully 3.0 percent by the time of the September forecasting round. It will be raised still higher on Thursday. However, crucially, the medium-term predictions continued to show inflation below target, effectively indicating that even the then current policy stance was too tight. Under its forward guidance, the ECB needs inflation to reach 2 percent well ahead of the end of its projection horizon and remain above that level for the rest of the forecast period if it is to move on rates.

Meantime, inflationary pressures continue to build. In October, the difference between HICP and PPI inflation was a remarkable 17.8 percentage points, up from 10.4 percentage points in August and 12.7 percentage points in September. Prior to this year, the largest gap over the last decade was just 3.8 percentage points back in March 2011. The average gap is zero. And the gulf is not just due to spiking energy costs as even the difference between October’s core rates was fully 6.8 percentage points, double the previous pre-2021 high set in February 2011. In other words, upside risks from pipeline prices remain intense and argue in favour of HICP inflation remaining both higher and for longer than previously expected. Technical factors, notably the elimination of distortions caused by changes to German VAT, all but guarantee a fall in both headline and core HICP inflation at the start of next year but a sub-2 percent rate at the end of 2022 will not be easy to achieve.

Crucially however, despite growing labour shortages wages still seem to be under control. In Germany, the construction industry has negotiated a 3.4 percent rise and retail just a 2.2 percent increase for next year. Over a million public sector workers last month secured a very modest 2.8 percent wage rise for 24 months. None of this seems likely to trigger a wage-price spiral – indeed, the deals agreed so far might even be too low to support a 2 percent inflation rate over the medium-term. That said, the newly installed German government has plans to raise the minimum wage by about 25 percent, a proposal heavily criticised by the Bundesbank.

Meantime, versus market expectations, Eurozone economic activity has been very mixed in recent months. Over the first half of the year forecasters consistently underestimated the pace of recovery – Econoday’s economic consensus divergence index (ECDI) was almost wholly above zero. However, since mid-August, there have been periods of significant underperformance. Moreover, on occasions such as now, even apparent outperformance is only due to positive shocks from the inflation components. Hence, although the latest ECDI reading is 11, indicating a modest degree of general outperformance, after removing the inflation contribution the real economy measure (RECDI) is in negative surprise territory at minus 14. Still, even that shows just mild underperformance which should not overly trouble the central bank. Nonetheless, importantly the economic recovery is far from complete. Real GDP and employment have yet to regain their respective pre-crisis levels, hours worked are down about 4 percent and nearly 2.5 million people are still part of some sort of job retention scheme. Moreover, there has been little hard data covering the period since Covid infections began rising very sharply again in mid-October.

The arrival of Omicron has made the economic outlook all the more uncertain. To date, the impact of the virus has tended to diminish with each wave but with intensive care units already stretched in a number of member states and winter just around the corner, the latest variant’s high transmissibility is a real concern. As a result, most Eurozone states have reimposed at least some Covid restrictions, including what is now a partial lockdown in Austria. These measures inevitably pose some downside risk to economic activity. However, while their initial impact has been seen in, amongst other things, lower oil prices, there is upside risk to inflation further out due to the potential additional disruption to supply chains.

In sum, the ECB faces a lot of unknowns. An increasing number on the Governing Council want to start normalising policy as soon as possible but, in the face of so many uncertainties, it is unclear what the ‘new normal’ should actually look like. Because inflation is so far above target, a slightly less dovish tone on Thursday is very likely but beyond that the central bank will most probably still toe a very cautious line. In contrast to some parts of the world, Eurozone monetary policy will remain highly accommodative for a long while yet.