June ECB meeting preview: Tapering without tears?

By Jeremy Hawkins, Senior European Economist
June 8, 2021

Market expectations are for no changes to the main policy levers at this week’s ECB announcement. Accordingly, this would leave the key pandemic emergency purchase programme (PEPP) at €1.85 trillion and net buying under the asset purchase programme (APP) at €20 billion a month. It would also mean that the refi rate is held at 0.00 percent while the rates on the deposit and marginal lending facilities stay at minus 0.50 percent and 0.25 percent respectively. At the same time, forward guidance should match April’s statement which saw the ECB expecting rates 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”.

However, against a background of rising inflationary pressures at home and abroad, financial markets will be looking for any hints that the central bank is about to start to discuss QE tapering. Recent comments from Governing Council members have indicated a seemingly widening split over whether the time has come to consider what to do once the PEPP has reached its (earliest) March 2022 termination date. The more cautious members, including President Christine Lagarde, have clearly indicated that they believe the Eurozone economy still needs ample monetary accommodation and that it is too early to contemplate reducing the PEPP. For others, where national HICP inflation rates are now above the near-2 percent target (the Luxembourg rate is currently 4.0 percent), the need to taper is seen as much more pressing.

As a starting point, what has proved to be a €20 billion step-up in PEPP purchases to €80 billion a month since the “significant” increase flagged at the March meeting to combat rising sovereign bond yields was supposed to be just temporary, lasting only through the second quarter. As such, the buying rate should be reduced by €20 billion next month and the ECB could confirm this on Thursday. However, even then, the tapering would just slow the speed at which the PEPP is (potentially) fully utilised and without a highly improbable cut in the €1.85 trillion ceiling, the overall thrust of policy would be unchanged. Still, financial markets might not see it that way and react negatively to any tapering announcement by forcing yields higher. As it is, although Eurozone yields have fallen in recent weeks, they remain well above their levels at the time of the March meeting (bunds up 8 basis points, BTPs up 0.61 basis points) and spreads are wider. Moreover, courtesy of less negative yield spreads versus the dollar, the euro has also appreciated further above the central bank’s assumed $1.20 pain threshold and so tightened monetary conditions. Consequently, the ECB might be tempted to reduce PEPP purchases only marginally – say by just €10 billion a month – or even simply stick with the current purchase rate. In any event, the decision is likely to be finely balanced and whatever the outcome, it could well impact bond markets.

That said, the key determinant of the next major shift in policy will be inflation. To this end, the ECB will present updated economic forecasts on Thursday amongst which the projected HICP profile will be even more important than usual. By and large inflation measures are on the up – indeed, at 7.6 percent the Eurozone’s annual PPI rate is currently at its highest level since September 2008. Even HICP inflation has moved above its near-2 percent target for the first time since October 2018. However, the official ECB line is that the current acceleration will be only transitory, being largely attributable to a range of one-off factors, notably Covid and oil prices. And so far, the data have been quite consistent with this view. Hence, according to the narrowest core gauge (which is at least as important to policymaking as the headline rate) underlying HICP inflation last month was just 0.9 percent, down 0.6 percentage points from January and only unchanged from a year ago. Moreover, the ECB estimates that annual wage growth, a key factor influencing inflation trends, was only 1.4 percent in the first quarter.

Still, the central bank is always keen to emphasise the need to keep inflationary expectations anchored and here recent developments have been more troubling. According to the EU commission expected selling prices in manufacturing hit a new record high last month while services saw their strongest mark since January 2020. That said, although household inflation expectations have increased every month so far this year, they remain well short of their pre-pandemic level.

In terms of the real economy, a (small) Covid-driven contraction in the region’s real GDP last quarter ensured a second double-dip recession. However, a gradual easing of virus restrictions has prompted a sharp rebound in business optimism which in a number of member states now stands at a record high. Leading indicators such as the PMI and the EU Commission’s economic sentiment index also suggest a steep pick-up in activity rates this quarter and a strong second-half to the year. Brexit remains a drag on growth but the effects now appear to be much less negative than they were at the start of the year.

In fact, since April’s meeting the economy as a whole has fairly consistently outperformed market expectations and Econoday’s economic consensus divergence index has been in positive surprise territory for almost the entire period. This warns that pressure on supply chains could be even more intense than currently estimated which would only make for additional upside pressure on prices until supply catches up with demand.

Business and investor sentiment has been significantly boosted by a surprisingly rapid decline in new Covid cases, in part reflecting the accelerating vaccine delivery. The ECB has previously expressed concerns about relative sluggishness of the rollout. Across the larger four member states, cumulative doses per 100 now stand at nearly 62, a rise of almost 80 percent since the end of April. This has allowed some countries to ease restrictions somewhat sooner than originally planned to the benefit of the economic recovery in general. Still, virus variants are becoming ever more transmissible and with a large proportion of the population yet to have even one jab, there remains the very real risk that a mutation capable of bypassing the current crop of vaccines evolves before the injection programme is completed.

So, in sum, while acknowledging that both the Eurozone real economy and inflation are gaining momentum, the overall tone of the ECB’s statement this week is unlikely to be very different from April. Crucially, the central bank can still be expected to highlight downside risks to economic growth from the coronavirus variants and at the same time dismiss the jump in inflation as only temporary. As such, any tapering to PEPP purchases will have to be communicated very carefully so as not to upset the fixed income markets and boost the euro. Indeed, if not already, how to taper without tears will soon be at the top of many central banks’ priority lists as the recovery from Covid finally comes within grasp.