The European Central Bank surprised the financial markets by completing, earlier than expected, its strategic monetary policy review a few days ago. The timing was a surprise but not the conclusion: The COVID-19 crisis has convinced ECB members that the 2% inflation target is not an efficient criterion with which to manage policy. This objective has been reached only few times since the inception of the euro, while current inflation remains well below its theoretical 2% long-term path.
A quick decision was needed to avoid the threat from exiting the Pandemic Emergency Purchase Programme too early. The inflation rate is not going to pass the inflation target for months. In a context of strong growth, it would make sense for the ECB to remove its very accommodative monetary policy first, and then start tapering PEPP in September with the goal of closing it by March 2022. In our view, it was important to clarify ECB monetary policy rules ahead of the German election in September, in order to avoid becoming a campaign talking point. Specifically, many uncertainties will remain at the time of the September ECB meeting, making inflation overshoot less of a concern than a fourth virus wave.
In its review, the ECB decided to change its well-known sentence defining its inflation target to “close to but below 2%.” The new approach differs from the Federal Reserve’s flexible average inflation targeting regime. Whereas the Fed will target an inflation overshoot as a policy objective, the ECB will tolerate an inflation overshoot without changing its policy. More details could be necessary to clarify its new strategy, but we understand that the persistence of very accommodative policy shouldn’t be impacted by a temporary inflation jump. As a result, we believe current expectations for an extended forward guidance with no hike before 2024 will likely remain unchanged.
Indeed, the ECB has reinforced its monetary policy flexibility to enable reaction to the evolving pandemic and its economic consequences. Considering our current view that the vaccine roll-out will provide protection from the severe illness, we expect no more lockdowns and anticipate an unchanged exit path for the PEPP. In our view, the program’s tapering will start in Q4 and reach maturity in March, to be absorbed by the Asset Purchase Programme for its remaining monthly purchase amount of (we forecast) around 20 billion.
In our view, the main consequence of the ECB decision is for the long-term outlook: higher inflation. So, we maintain our current scenario of a small rise on long-term rates, going back on positive territory, with a long exposure to inflation products.