July ECB meeting preview: Seeking forward guidance

By Jeremy Hawkins, Senior European Economist
July 20, 2021

Having seen the June ECB meeting extend the period of increased asset purchases under the pandemic emergency purchase programme (PEPP) through this quarter and with minimal chance of any change to either the asset purchase programme (APP) or key interest rates, market expectations for this week’s ECB announcement are suitably subdued. The consensus is firmly in favour of the ceiling on the PEPP being left at €1.85 trillion through at least March 2022, net buying under the APP continuing at €20 billion a month and the refi rate being held at 0.00 percent with the rates on the deposit and marginal lending facilities remaining fixed at minus 0.50 percent and 0.25 percent respectively.

However, in the wake of the shift earlier this month to a new symmetric 2 percent medium-term inflation target, the central bank will have to adjust its forward guidance. Prior to tinkering with the target, QE was expected to end shortly before the first hike in interest rates and key rates were expected to remain at their “present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2 percent within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics”. The text relating to the inflation target is no longer appropriate and its amendment could afford the central bank the opportunity to provide some fresh insights into the conditions required to taper QE and, ultimately, tighten policy. In a nutshell, the new slightly higher target (and accompanying structural review statement) gives the ECB a little more flexibility in its policy decisions and, at the margin, could slightly defer the time when interest rates are finally hiked. The revised forward guidance might reinforce this view although with clear splits on the Governing Council, agreeing on any changes may not be easy.

June’s (majority) decision to maintain third quarter PEPP purchases at “a significantly higher pace than during the first months of the year” reflected both the central bank’s caution about the state of the economy and its concerns about the deteriorating financing conditions being caused by a combination of higher sovereign bond yields, widening spreads and a stronger euro. However, in recent weeks, bund yields have fallen back beneath their levels at the time of the March policy announcement, spreads have narrowed and the euro has lost around 4 percent versus the U.S. dollar. Importantly too, the ECB’s new bank lending survey found essentially stable credit standards and stronger loan demand last quarter, suggesting that financial conditions are not hampering the economic recovery. All of this should sit well with the central bank and so further bolsters the case for no change in policy this week.

That said, the economy is another matter. On the upside, real GDP growth almost certainly moved easily back above zero last quarter and recent economic data have fairly consistently been on the strong side of the market consensus – Econoday’s economic consensus divergence index currently stands at a respectable 21. In fact, on average overall economic activity has quite easily beaten expectations since the start of the year.

However, on the downside, while headline growth may be accelerating (and business surveys remain very bullish about the near-term outlook) its composition leaves a lot to be desired. As usual, individual performances vary markedly across the region but in many states the recovery in demand is easily outstripping supply. Hence, since just before the pandemic in February last year, retail sales volumes in France and Germany have grown around 14 percentage points and 10 percentage points respectively more than industrial production. Italy is an exception with a gap of minus 2.3 percent (which probably helps to explain why Italian core CPI inflation is just 0.3 percent) but for the Eurozone as a whole, real sales have risen nearly 5 percent more than goods production. The region’s core inflation (0.9 percent in June) is actually still very low but this excess demand is adding to the upside risks already posed by several months of the sharply increasing raw material costs. Indeed, the ongoing disruptions to global supply chains and the subsequent shortages of raw materials are not just boosting cost pressures directly but, by constraining the upswing in output, they are also creating excess demand. In fact, in most Eurozone countries bullish manufacturing PMI surveys are misleadingly firm since some 25 percent of the headline index is attributable to components (vendor delivery times and stocks of purchases) whose gains essentially just reflect input shortages.

Nonetheless, the biggest worry for the monetary authorities is the renewed and steep rise in Covid infections prompted by the highly transmissible Delta variant. From a peak of around 165,000 weekly new cases in early April, the EU infection rate fell sharply and was below 12,000 a week in late June. However, numbers are now climbing rapidly again and although death rates remain low, a jump in cases forced the reintroduction of fresh restrictions in France, Greece, the Netherlands and Spain just last week. The Dutch government has conceded that its decision to lift containment measures in June was premature. So far, the latest measures are nothing like as aggressive as seen previously but they will still slow the economic rebound and the chances are that other states will have to follow suit. Happily, the vaccine rollout has continued apace but the outcome of the race between it and the virus remains very uncertain and financial markets would seem to be reassessing risks to the recovery process.

Until the release of the structural policy review, Thursday’s announcement looked likely to be something of a damp squib with policy effectively set until the third quarter’s reassessment of the PEPP purchase rate. However, the review has helped to whet investor appetites and both the official statement and the press conference could now have a much more significant impact than previously anticipated. In general, it still seems likely that the overall tone of the meeting will be at least moderately dovish despite conflicting views on the Governing Council. But, whatever the outcome, the ECB faces some tricky problems for policy, not least how to deal with rising inflation pressures that are becoming as much a function of inadequate growth of output as they are of recovering demand.