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European Central Bank: New wording, old problems

ECB confirms dovish bias of its new strategy. In its closely-watched pre-holiday meeting, coming close on the heels of its strategy review, the ECB offered its first indications on how the new inflation target - raised from “close to but below 2%” to a symmetric medium-term target of 2% - will be implemented. Facing a trilemma between price stability (inflation target), financial stability (preventing fragmentation) and minimizing the balance sheet risk (avoiding fiscal/financial dominance), the ECB had moved  towards price stability but remains strategically orientated in the “QE infinity” section.

We consider that the implementation of the new strategy offers more potential for dovish rather than hawkish policy. The changes to the forward guidance made today already go in this direction, with the dovish shift on inflation and key rates from the strategy review confirmed. Hikes can now only occur if inflation reaches 2% "well ahead of the end of its projection horizon” (currently 2023) while “transitory” periods of “moderate” overshoot are allowed. The communication on Quantitative Easing (QE) remains largely unchanged. The decision on the tapering of the Pandemic Emergency Purchase Program (PEPP) has been pushed to Q4, probably together with the release of the new forecasts in September. The outlook for the usual open-end Asset Purchase Program (APP) remains also largely unchanged. 

New wording, old problems. Rates markets have so far not embraced the ECB's new inflation target. Long-term inflation swaps and forward swaps remain well below the new target (10y swap at 1.5% , 5y5y forward swap at 1.6%). Money markets have taken a more dovish position than a month ago, pricing no significant rate hike before 2024. With today's meeting, the lift-off could be priced even further back. Regarding bond purchases, we believe the new strategic framework has limited the scope for an early tapering. With its inflation forecast currently at 1.4% in 2023, the ECB - at least under a strict interpretation of its new target - can hardly scale back the pace of its bond purchases. However, some hawkish members of the governing council had already pleaded for tapering the purchases in June, given the quick economic recovery. In addition, the PEPP, which accounts for 80% of the current bond purchases, is going to expire in March 2022. Today's meeting did not provide further information on this. Uncertainty around the spread of the Delta variant may have bought the ECB some time. But in the coming months, it will have to adress the conflict between its strategic inflation target, operational constraints (PEPP deadline, volume and issuer limits, market neutrality) and hawkish concerns.


Patrick Krizan
Allianz SE