September ECB meeting preview: Covid and the cracks in policy

By Jeremy Hawkins, Senior European Economist
September 7, 2021

With official interest rates still pegged at record lows and apparently seen to be at their effective lower bound (ELB), financial markets will again be focusing on what Thursday’s ECB announcement has to say about QE. The June meeting extended the period of increased asset purchases (currently around €80 billion a month) under the pandemic emergency purchase programme (PEPP) only through the current quarter. Consequently, the central bank will soon have to decide if it wants to stretch the period beyond September or revert, partially or fully, back to the €60 billion buying rate seen earlier in February. What it chooses to do will be heavily influenced by a newly updated set of economic forecasts.

July’s decision to maintain the monthly buying rate at the higher level through the third quarter was not unanimous and with Eurozone inflation well above target and the economy expanding again, the more hawkish Governing Council members will be keen to unwind March’s boost to QE. However, the ECB’s majority view is still that the recent rise in inflation will be only transitory and, in some quarters, there must be concerns that the nascent economic recovery is already losing momentum. Consequently, while the market consensus is for the monthly PEPP rate to be tapered in the fourth quarter, it is far from a done deal. Either way, the central bank could opt to provide some indication of what it plans to do with the PEPP next year (although Chief Economist Philip Lane late last month suggested that there is no hurry to make any such decision). The programme was only supposed to address the Covid crisis and is currently earmarked to be wound up at the end of March 2022 (but not any sooner). This would still seem to be the market’s call but until the Covid picture becomes clearer there must be a risk that the deadline is extended. That said, if QE is tapered, even a deferred termination of the PEPP need not have any implications for its overall size as around €500 billion of the €1.85 trillion fund is still available for future purchases.

Meantime, no changes are expected to the longstanding asset purchase programme (APP) where net buying should remain at €20 billion a month and, on the basis of unmodified forward guidance, only end shortly before the ECB starts raising the key interest rates. On that front, there would seem to be a near-zero chance of any move over the foreseeable future. Accordingly, the refi rate should stay 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. The newly amended forward guidance should also be untouched, leaving the central bank expecting rates “to remain at their present or lower levels until it sees inflation reaching two percent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two percent over the medium term.”

Crucial to Thursday’s decision will be the central bank’s assessment of the borrowing climate. The maintenance of favourable financing conditions has become the ECB’s top priority and any deterioration here could have significant implications for policy. However, while around 20 basis points above their July/August lows, 10-year bund yields are still about 25 basis points short of their May peak and the Eurozone yield curve is negative out to 20 years. Just as importantly, spreads also remain historically tight. As such, the central bank should be happy enough.

Even so, while the minutes of the July meeting indicated that the Governing Council thought the Eurozone economy was performing roughly in line with their June forecast, more recent data have suggested that there has been some loss of momentum. In particular, the EU Commission’s closely watched economic sentiment index fell in August for the first time since last November and last month’s PMI composite output index also lost ground. Moreover, retail sales nosedived in July, providing support for the view that rising prices may now be posing a threat to household spending. At the same time, the labour market continues to improve but the jobless rate is still 0.5 percentage points above the low seen in March last year.

In fact, since mid-August, overall economic activity has largely undershot market expectations – indeed, late last month Econoday’s economic consensus divergence index posted its weakest reading since November 2020. To be sure, recent readings would be deeper in negative surprise territory but for the unexpectedly sharp jump in inflation shown in both the latest HICP and PPI reports.

Indeed, with HICP inflation now at 3 percent, its highest mark since 2008 and a full percentage point above target, the ECB’s hawks will be pressing hard to start talking exit strategies and will want to taper QE as soon as possible. The central bank’s June forecasts showed inflation at 1.9 percent at year-end but, in the absence of a surprise slump in commodity prices, this now looks implausibly low and so is likely to be revised up. Depending upon the size of the adjustment, the hawks’ case could well be strengthened, all the more so now that the EU’s Recovery and Resilience Facility is finally starting to provide much-needed fiscal support to member states. As it is, upside pressure on prices from the manufacturing sector remains intense and at some 9.9 percentage points, the current gap between the annual PPI and HICP inflation rates is ominously wide.

The rapid pick-up in the vaccine delivery programme appears to have stopped what was becoming a worryingly steep upswing in new Covid cases from late July. The latest readings are still uncomfortably high but the peak looks to have been reached at the end of July, since when the infection rate has started to drift down. Hospitalisations have also stayed relatively low. Developments here are important as the virus has been cited by the ECB on many occasions as being a potential major threat to the recovery, a view likely to be reiterated this week.

In sum, Thursday’s announcement may not be the most exciting of the year but behind the scenes differences in members’ views about the appropriate stance of policy are likely to be widening. Some hints about possible QE tapering may be forthcoming but in the main, another generally dovish statement and press conference that seek to mask the policy cracks still looks the best bet.