Via Societe Generale:
After a tumultuous first year, it looks like president Lagarde’s ECB is gradually finding its feet and defining its new modus operandi. Wisely, we believe the ECB will now be less sensitive to market pressure and inflation expectations, calling increasingly on fiscal policy to be engaged in determining future inflation.This also reflects the limitations of monetary policy, especially in the context of already low interest rates and weak underlying inflationary pressures. A more realistic objective than aiming for 2% inflation two to three years ahead is thus to focus on protecting favourable financing conditions, at the lowest cost possible, while allowing a longer period for inflation to converge to target. We thus see the ECB on hold in the near term, although growth expectations are weakening amid prolonged lockdowns. Instead, we expect the ECB to focus on the strategy review with the aim of finding consensus views before the summer.The expected reformulation of the inflation target to a symmetrical one around 2% should not be controversial or have much impact on markets. We also hope that the ECB will clarify that it is meeting its democratic mandate even at(positive)inflation rates below that target. More problematic,in the second half of this year, will be to communicate and implement an eventual end of the PEPP in 2022 without causing market volatility. Early and bold under-purchasing in the PEPP this year may be a way of signalling the intent to focus on appropriate financing conditions(i.e. yield levels/curves) rather than any particular balance sheet size, and we would not exclude maintaining a large purchase envelope beyond March 2022 to discourage fragmentation. Such innovations and thoughts about long-term exit strategies should also be explored in the strategy review. For next week’s meeting, we expect no specific policy message, with the focus instead on the economic outlook.4Q20 better than expected; 1Q21set to be worse.The economic data for 4Q20, especially from the manufacturing sector,have surprised on the upside, suggesting that the slowdown in economic activity could have been milder than previously thought. Preliminary data from Germany this morning confirmed this, pointing to unchanged quarterly growth in 4Q, much better than expected. In contrast, the extensions and tightening of lockdowns in most countries will have a dampening impact on growth in1Q, with the latest, and more contagious, strain of the virus providing additional uncertainty(possibly requiring 10 more weeks of lockdown in Germany, according to Merkel this week). While the ECB wil lnot publish new forecasts at this meeting, there will be much interest in how it sees the outlook in light of the latest economic developments. We believe Lagarde will have the same thoughts as us concerning 4Q and 1Q changes but will otherwise broadly maintain the views expressed in December, with risks still tilted to the downside.Only if the ECB decides to take the 2% target within two to three years more seriously would we expect further action this year. However, it already had inflation below 1.5% at the end of its forecast horizon in its three latest forecast rounds, so we believe the view is now firmly accepted that meeting the target is only possible beyond the forecast horizon. Other reasons for expecting more action this year would be if the medium-term forecasts were to deteriorate materially or if the current mix of instruments is deemed ineffective. If the euro continues to appreciate strongly, a rate cut may again be discussed.TLTRO uptake may not be greatGiven the uncertainty and risks, the need for more action cannot be excluded.We are particularly concerned that the weak incentive structure of the additional TLTROs, announced in December, will fail to generate much new demand from banks. At the time of the improved TLTRO conditions in spring 2020, it was relatively easy for banks to meet the conditions for the lowest available interest rate (-1%, a de facto subsidy)as demand for loans was high. To get the same interest rate now, banks would need to keep lending volumes unchanged from October 2020 to December 2021, something that looks increasingly challenging given the weak outlook. Instead, the best hope is to keep the outstanding TLTRO volume unchanged through this year. Moreover, the ECB only expanded the borrowing allowance by 5pp to 55% of eligible loans, suggesting that peripheral banks, which might face the greatest demand, may struggle to make use of the new TLTROs.With weaker demand from companies, reduced liquidity risk needs and less opportunities for carry-trade operations, banks may instead repay some of the TLTRO loans this year. However, demand for mortgage loans has continued rising, something that will please the ECB while reducing the likelihood of it extending theTLTROs to the household sector.Work on the strategy view likely to consume the ECB in 1HWith a less urgent policy agenda, the ECB will finally need to sit down and reflect on this year’s strategy review, due to be published after the summer. On the most important aspect for policy, the inflation target, the perceived change in the ECB’s reaction function we saw last year, focusing on financing conditions rather than hitting the inflation target in two to three years time, suggests that it will take more to change markets’ inflation expectations than resetting the inflation target to a slightly higher and symmetric target (around 2%). The strategy review should thus be a non-event as regards the ECB’s reaction function, with uncertainty on what more the ECB can do remaining high. Instead, market inflation expectations may be more influenced by fiscal policy action and incoming data on the economy. We continue to see very low inflationary pressures this year, with labour markets deteriorating across the board. Hopefully, the strategy review will also offer some thoughts on the benefits of alternative strategies, such as yield curve control and its limitations in the euro area context. We will also be looking for clues on long-term exit strategies (a request by the German constitutional court)and views on the optimal size of the balance sheet. The other work-streams of the ECB’s strategy review (climate change, digitalisation, modelling, fiscal and monetary policy coordination, globalisation, inflation expectations, inflation measurement, macroprudential & financial stability, communication, non-bank financial intermediation, productivity, innovation & technological progress) will all provide valuable insights into ECB thinking but will likely impact policy less. We particularly look forward to the findings on (low) productivity growth in the euro area and the need for continued reform, while the target inflation measure would hopefully include owner-occupied housing costs.
In short, it’s a good bet that Europe will undercook both monetary and fiscal stimulus versus the US this year meaning it will not be able to reverse EUR gains until 2022 when markets weigh rising US yields and crushed European inflation more seriously.