The ECB: So Much Flexibility and So Little to Do

The ECB meeting is the most important calendar event in the week ahead.  It is true that the US reports February CPI figures, but the base effect surge begins with the March reading.  Still, headline inflation will likely be lifted by rising food and energy prices.  The core rate has been flat for the past two months, and a small rise should not be surprising.  

Last March, headline CPI fell by 0.3%.  In April, it tumbled 0.7% and another 0.1% in May.  These will drop out of the year-over-year rate and most likely be replaced with positive numbers, probably around 0.2% or 0.3%.  This will make the year-over-year rate appear to surge. 

This is not the kind of inflation that is of much concern to policymakers or businesses.  The February PMI and manufacturing surveys are signaling rising prices.   Fed officials seem to recognize this, but on the whole, the price pressures are not unexpected, undesirable, or dangerous.  They are partly a reflection of the economy re-opening, some bottlenecks, and low inventories.  Officials have argued that they do not expect these price pressures to be very strong or persistent. Businesses can be expected to respond relatively quickly to supply issues and low inventories.  This type of price pressure is seen as short-lived. 

The pressures coming from the demand side are also not expected to be sustained.  Fiscal stimulus will run its course.  The stimulus checks will have been absorbed in household finances, and in late Q3, some income support measures, like the extension of emergency jobless benefits, will end.  More broadly, the herd immunity, achieved through the virus and vaccine, will likely mean that fiscal stimulus will be dramatically reduced. The next debate after the infrastructure initiative may be about the "fiscal cliffs."   We had argued in favor of linking some stimulus efforts to economic conditions, like maintaining emergency jobless benefits until the unemployment rate is below a certain threshold to minimize the disruption. Still, it did not make it into the legislation.  

There does seem to be a rising chorus of people, for whom the highly-respected journalist John Authers may have channeled for when he wrote recently wrote about the "epochal shifts [in inflation] can be difficult to spot in real-time, but the signs are there."  While journalists and some market participants may see this shift as clear as the nose on my face, central bankers mostly disagree. The BOE's Haldane may be a lone exception, warning that central banks may be complacent about inflation.  

Fed officials are not buying it is primarily due to the slack in the labor market.  Nearly a year after the pandemic first stuck, the number of people filing for jobless claims for the first time is above what had been the record peak during the Great Financial Crisis. The March jobs report was nearly twice as strong as expected, and the vast majority of the 465k private sector jobs were in leisure and hospitality. It leaves the US with about 9.5 mln jobs less than a year ago.  The number of long-term unemployed rose by 125k last month to 4.1mln, an increase of 3 mln over last February.  And let's not forget that on the eve of the pandemic, when unemployment, including minority unemployment and underemployment, was at its lowest in a generation, inflation was still undershooting the Fed's self-selected target.  It was not just in the US either.  Inflation was typically undershooting at the peak of the last cycle.  

There seems to be a tendency for market observers to prematurely claim structural factors for what ultimately is a cyclical phenomenon.  That tendency also seems to encourage the removal of stimulus early after the Great Financial Crisis, which is recognized now by both the US Treasury Secretary and Federal Reserve Chairman as a mistake.   Ironically, some who argued against longer and more stimulus after the GFC and plea mea culpa now,  like Summers, is worried that he might be right this time.  

Perhaps, there is also a disagreement about the direction it would be preferable to wrong.  One type of mistake is if it is a structural shift, a new regime after a 40-year decline, and policymakers do not recognize it as such. Inflation can be elevated for some time, undermining the domestic purchasing power of the dollar.  Central banks know how to fight inflation, and they would tighten financial conditions. On the other hand, what if the rise in price pressures is mainly due to economies opening back-up in an unsynchronized and uneven way and is part of the recovery from the unprecedented shutdown? If officials are led to believe it is a structural and epoch-making inflection point, they would once again take away the punchbowl too early. Given the stress still evident in the labor market, such an error could have grave social and political consequences, especially given the erosion of social trust.  

The eurozone lags behind the US on three important metrics. The US policy response has been far more aggressive. Partly, as a consequence, the recovery is weaker. While US economic growth appears to be surging, the eurozone is likely contracting. The vaccine rollout in the eurozone is proceeding at a slower rate than in the US. The rise in eurozone yields appears to be a knock-on effect of US developments. Though, when in word and deed, ECB plays down the significance of the increase in yields, it seems to egg on the market further and may have, in turn, weighed on US Treasuries.  

Fed officials, including Chairman Powell, take the rise in US yields in stride, even if the pace and volatility were a bit unsettling.  The rise in European yields, should they continue, may slow the recovery.  The ECB's staff is likely to trim its growth forecast and raise its inflation forecasts at the meeting on March 11.  In December, the forecast for this year's growth was cut to 3.9% from 5.0%.  The March forecast will likely be trimmed further below the median estimates in Bloomberg's survey for a 4.2% growth.  

The ECB forecasts CPI to rise by 1.0% in 2021.  This was unchanged from its September forecast.  It seems less reasonable now.  The preliminary estimate for February put the year-over-year pace at 0.9%.  While the US base effect will be pronounced in the March-May period, the eurozone's happens in July and August.   Since the end of October, the price of Brent has risen almost 90%, and there appears more to come.  Energy accounts for more than 50% of the ECB's harmonized CPI measure.  

The exchange rate is another important component of the eurozone's measured inflation.  ECB officials are inclined to talk about it when the euro is appreciating.  The euro has fallen by almost 2% so far this year against the dollar and by nearly 3% against the currency of its biggest trading partner, China.  With the euro around $1.20, it is about 16.6% undervalued according to the OECD's model of Purchasing Power Parity.  

ECB promised a more robust discussion of financial conditions and how they are measured. The central bank's chief economist has cited the exchange rate, equities, and the slope of the overnight index swaps and the 10-year yield curve.  Europe's equity benchmarks are less heavily weighted toward tech and have a greater weight of the energy.  However, the performance of Europe's Dow Jones Stoxx 600 and the S&P 500 is now so different (2.4% vs. 2.3%, respectively). Europe's sovereign curve has steepened by roughly 20-30 bp year-to-date.  The US 2-10 curve has steepened by closer to 65 bp.    

The real question is, what is the ECB prepared to do about it.  The first thing that seems to occur to observers is to increase the amount of bonds being purchased.  The most obvious answer may not be the right one. However, it is true that unlike the Fed, which seems unwaveringly committed to buying $120 bln of long-term assets a month, the ECB has a fund ("envelope") that is really more of an agreed-upon but sell-imposed buying cap (1.85 trillion euros).  It has the ultimate flexibility and is not limited to the capital key (weighted by GDP and population).  

The ECB does not want to defend a pre-determined bond yield.  There is no yield-curve control policy implicit or explicit.  Even if the ECB wanted, it is not clear that it can dictate the price of long-term capital for long.  A global market is developed even if with varying levels of volatility. The general direction appears global in nature. The Fed is buying $80 a month of US Treasuries, and still, the yield has doubled since early November.  

ECB President Lagarde will emphasize the flexibility in all of its tools and dimensions.  It could step up its bond purchases, but it might not be evident in the price action. The only way the market will know is in hindsight after the ECB issues its report.  Some suggest the ECB will extend its PEPP beyond March 2022, but the time for such a decision is not now.  The ECB could announce it will extend the favorable terms of the Targeted Long-Term Refinancing Operation--in effect, three-year loans at 50 bp below the deposit rate (currently at minus 50 bp) if certain loan targets are achieved.  Extending them another year, through June 2022, provides cheap credit and blunts the impact of the negative deposit rate.

There is some speculation that the ECB may cut the deposit rate, and some officials have suggested this is possible. With the certitude of the zero-bound being pulled from under our feet, it is not clear how deep into negative territory interest rates can fall.  Many suspect it could be around minus 100 bp. That gives the ECB some scope to cut the deposit rate.  However, the missing element here is will.  There does not seem to be much confidence that lowering the negative deposit rate would greatly impact the long-end of the curve.  

Officials are likely to conclude that there is little new to do now.  The market is adjusting to the greater confidence of an earlier and stronger US recovery and the anticipation that Europe will not be that far behind.  The bond market did not wait for the eurozone recovery to take hold, but neither did oil or commodities more generally. That is not the way things work.  

The EC has given strong hints that it is prepared to extend the fiscal waiver for 2022.  Several eurozone countries either announced an increase in spending this year or are drafting programs now.  The EU Recovery Fund is expected to begin making disbursements toward midyear.   Fiscal policy is expansionary, and it is not clear that the US is a fair metric.  

Monetary policy is still ultra-accommodative by nearly any metric, and European yields should not be exaggerated.  Italy can borrow 10-year for less than 75 bp, half of what it was on the eve of the pandemic, for example.  Germany is still paid to borrow for 10-years (~-0.35%).  Portugal's 10-year bond yield trades inside Spain's. 

Look for good old-fashion jawboning and some strategic ambiguity from the ECB, while fiscal policy and the vaccine do some heavy lifting now.  An extension of the favorable terms for the TLTRO coupled with dovish rhetoric would appear to be negative for the euro.  Lagarde may very well echo Powell's sentiments to wit the ECB is focused on financial conditions broadly, not on specific bond yields.  The only problem with that is the sell-off in US bonds sparked by Powell's apparent lack of much concern about the level of rates even if the pace was jarring.