By Jeremy Hawkins, Senior European Economist
February 1, 2022
Having already laid out its 2022 policy plans at the December meeting, Thursday’s ECB announcement is unlikely to contain any real surprises. Key interest rates will remain on hold (refi rate 0.00 percent, deposit rate minus 0.50 percent) and moreover, if Chief Economist Philip Lane is correct, will be held at current levels over the rest of the year. With regard to QE, the pandemic emergency purchase programme (PEPP) is now being run down and will finish at the end of this quarter. In addition, through March the monthly target for purchases made under the asset purchase programme (APP) will stay at €20 billion. All of this is fully discounted in financial markets.
At €1.60 trillion, the PEPP still had some €0.25 trillion available for additional acquisitions in December. However, reaching the €1.85 trillion ceiling by the cut-off date at end-March would require an increase in the purchase rate which would go against the current exit strategy. This means that it is very probable that the programme will be terminated before it has been fully utilised. That said, as the central bank has always been keen to point out, the PEPP is flexible with no fixed monthly target and purchases might yet be stepped up temporarily with Omicron cases so high and bond yields under upside pressure.
Beyond this quarter, the hole in QE left by the disappearance of the PEPP will be partially filled by a boost to APP buying. The second quarter will see the monthly target doubled to €40 billion before being trimmed to €30 billion in the third quarter and reverting back to €20 billion in October-December. The APP remains open-ended and forward guidance sees purchases only ending shortly before the first hike in interest rates. Outright asset sales (quantitative tightening or QT) to shrink the ECB’s balance sheet are not anticipated until well after the rates have gone up.
As it is, some members of the Governing Council will not be happy with the recent spike in sovereign bond yields. Maintaining favourable financing conditions remains a key goal of policy so compared with the December meeting, 10-year bund yields around 35 basis points higher and Italian spreads nearly 10 basis points wider will be seen as a threat. That said, the central bank’s new lending survey should come as something of a relief; finding no significant tightening of credit standards on loans to enterprises and a further loosening of standards on lending for house purchase and consumer credit.
The ECB seemed reasonably upbeat about the economic outlook in its December forecasts and, despite some mixed releases, the bulk of the recent data has been on the strong side of market expectations. Throughout most of January, Econoday’s economic consensus divergence index (ECDI) was fairly consistently above zero, even after adjusting for positive shocks from the inflation components (RECDI). Indeed, in mid-month the RECDI posted its highest mark since last August. Nonetheless, the latest data have disappointed and are a reflection of how Covid continues to have an important negative impact. The highly transmissible Omicron variant has pushed new cases to record highs, hitting both demand and output, particularly in services where the number of people having to self-isolate has climbed sharply.
In fact, the flash January PMI survey showed activity in services expanding at its slowest rate in nine months. In the same vein, the European Commission’s economic sentiment survey found a particularly steep decline in sector confidence in December followed in January by its weakest print since last April. Provisional quarterly Eurozone GDP growth of just 0.3 percent last quarter was held in check by a renewed contraction in Germany (minus 0.7 percent) where the hit from broken global supply chains has been disproportionately hard on its key manufacturing sector. The other larger member states all fared much better but over 2021 as a whole, the ECB estimates that supply chain disruptions subtracted about 0.5 percentage points from Eurozone economic growth.
Meantime, HICP inflation might well have peaked. December’s HICP showed the annual rate edging up just a tick to 5.0 percent, its smallest increase since it last fell in June. Moreover, the narrow core rate (2.6 percent) was only unchanged, the first time it has not risen since July. January will see the end of the distortions caused by changes to German VAT which should mean that, purely on technical grounds, both headline and core inflation will decline. Nonetheless, pipeline pressures have been building for a long time and the gap between Eurozone HICP and PPI inflation is now almost 19 percentage points. There have been some tentative signs that supply chain blockages have eased a little recently but near-record Covid cases around the world warn that getting the HICP rate back to 2 percent will not be easy.
Covid remains a serious downside risk to the economy at the start of 2022. The arrival of Omicron, already the dominant strain across much of the region, has seen new cases rise exponentially and easily surpass the highs seen in earlier waves. Fresh measures were introduced in many Eurozone states in December to limit the spread. In the last few days, some governments have begun to lift the restrictions but, in both France and Germany, the new rules remain in place. Vaccines continue to be effective but the rate of inoculation is slowing and worryingly, resistance to the jab is still strong in eastern bloc countries.
The minutes of the ECB’s December meeting underlined significant splits on the Governing Council and these may well have widened since then. Inflation is the big issue but the central bank will also be alert to the potential fallout from the very real risk of a Russian invasion of Ukraine. A shift in the central bank’s stance this week remains most unlikely but with official interest rates already headed, or about to head, higher in a number of major economies, the hawks must be becoming increasingly worried that simply watching from the sidelines will leave Eurozone policy falling behind the curve.