The December 2020 meeting of the European Central Bank (ECB) focused once again on asset purchases and generous liquidity provisions to the financial sector instead of lowering policy rates further, in line with our longstanding view that the ECB is near the effective lower bound on the deposit facility rate.
The ECB unveiled a package of monetary policy measures broadly in line with market expectations. The package included:
- An additional €500 billion of net asset purchases via the pandemic emergency purchase programme (PEPP) until at least the end of March 2022, taking the PEPP to €1.85 trillion. This amount will be in addition to the open-ended €20 billion monthly net asset purchases.
- Additional TLTRO (targeted longer-term refinancing operations) beyond March 2021, as well as an extension of the preferential -1% interest rate period under TLTRO-III to June 2022.
- Additional pandemic emergency longer-term refinancing operations (PELTROs), an extension of the temporary collateral easing measures to June 2022, and a continuation of regular lending operations as fixed rate tender procedures with full allotment.
A fresh round of quarterly staff macroeconomic projections has been released, and the inflation trajectory over the next three years remains bleak. The 2023 core and headline HICP inflation forecasts sit at 1.2% and 1.4% respectively; in other words, the ECB projects to solidly miss its own definition of price stability under the recalibrated monetary policy configuration for another three years. Hence asset purchases are likely to remain the dominant component of the monetary policy mix over the secular horizon and, similar to the Bank of Japan (BOJ), sustainability considerations will likely gain in importance over time. We believe the ECB’s recent shift in narrative reveals the direction of travel, namely a gradual transition from quantities to prices to effectively some form of yield curve control.
The ECB leadership has made frequent reference that it doesn’t target easier financial conditions but rather aims to preserve current borrowing conditions for an extended period of time. Relying less on interest rates and more on asset purchases means that, like the BOJ, the ECB has de facto subordinated monetary policy to elected government officials in charge of fiscal policy. As fiscal policy is considered the instrument of choice in an environment of elevated uncertainty near the effective lower bound, the ECB’s role chiefly consists of enabling fiscal policy and ensuring favourable financing conditions for the private and public sector of the euro area economy. In her commanding “Sintra” speech on 11 November, ECB President Lagarde mentioned “financing conditions” 12 times and argued for countering upward pressure on market interest rates. A focus on financing conditions instead of financial conditions relegates equity and currency considerations to a lower priority, and elevates yield curve control.
What to expect
In line with the coordinated monetary and fiscal actions seen in other countries, it is important to recognise the differences between a single sovereign state and a monetary union such as the euro area, where the ECB deals with yield curves of multiple jurisdictions and faces additional legal complexities. Accordingly, and contrary to the BOJ, the institutional setup of the euro area presumably discourages the ECB from engaging in overt yield curve control, and the ECB will likely refrain from officially announcing simple numerical targets for the GDP-weighted euro area sovereign yield curve as a result. We believe the ECB will instead opt for fortifying language on preserving borrowing conditions and on leaning against crowding-out of private sector activity, and will prioritize prices over quantities in the day-to-day implementation of its asset purchase programmes. This entails some execution risks, including the risk of unconstructive ambiguity regarding the monetary policy reaction function in what will, in euro area context, by necessity constitute a blend of yield and spread curve control.
We believe PEPP is currently the appropriate instrument for loose yield curve control (LYCC) in the euro area as the PEPP is both about the overall monetary policy stance and about the transmission channel, and the ECB will likely continue to use the PEPP’s in-built flexibility for LYCC, depending on whether stance or transmission considerations prevail, with the aim of preserving easy borrowing conditions for all euro area jurisdictions for the duration of the pandemic. Once the pandemic-related effects on the inflation path are sufficiently neutralized via temporary policy measures like the PEPP, we believe more regular asset purchase tools will come back to prominence in order to fine-tune the post-pandemic monetary policy stance and deliver LYCC. The more clearly the ECB eventually chooses to communicate the reaction function, the less assets it will have to purchase under LYCC as the private sector will be crowded in and co-invest. In this context, the ongoing ECB strategy review is expected to assist in shaping and communicating the role of monetary policy near the effective lower bound.
What does LYCC, and the focus on financing instead of financial conditions, mean for investors? We expect duration to remain reasonably range-bound, interest rate curves to exhibit a steepening bias, spread sectors to remain better anchored, and the EUR currency to face less appreciation resistance.
To learn more about PIMCO’s latest views, don’t miss our latest Secular Outlook.