MACRO AND MARKET PERSPECTIVES

ECB relaxes constraints on policy easing

Framework change marks another step in the global
shift by central banks to adopt new strategies that
carve out more policy space – now and in the future.

Summary

The European Central Bank (ECB) has made a significant change to its monetary policy framework by adopting a symmetric objective around its 2% annual inflation target. While this might look like a technocratic tweak, the new policy framework permanently loosens the previous constraints to deliver easier policy, in our view. This brings the ECB framework in line with most other major central banks. But importantly, we believe this is part of a global trend to relax the constraints preventing looser policy relative to former frameworks.

Since the global financial crisis (GFC), the ECB has struggled to restore price stability by keeping inflation and inflation expectations anchored “below but close to 2%” – its previous target. Now the ECB has opted for a symmetric target around 2% – and also indicated it will deliberately tolerate moderate and temporary overshoots when needing to act strongly in view of the effective lower bound (ELB), below which interest rates cannot be reduced further. The Federal Reserve is going one step further by explicitly aiming for overshoots to make up for past shortfalls.

When adjusting our economic projections for the new framework and ECB reaction function, we find it could lead to a roughly 20-30 basis point rise in inflation and a 30-40 basis point increase in GDP growth. Policy rates would be lower than in the previous framework: we no longer see the ECB lifting rates from their current -0.5% level on a five-year horizon versus our previous expectation for lift-off in 2024. Currently, asset purchases are set to continue until shortly before interest rate lift-off, so regular asset purchases will need to be stepped up beyond the pandemic-emergency purchases that are due to expire in March 2022.

We assess how ECB policy might have differed if this framework had been in place earlier. Not only do we think the ECB would not have hiked rates in 2011, it would have been more forceful in easing in 2014-2016 via an earlier launch of large-scale purchases of public debt.

Based on the ECB’s forward guidance, implementation of the new ECB strategy should lead to additional asset purchases for several more years. It should also foster higher inflation expectations in the euro area, underpinning our new nominal investment theme.

Elusive price stability

Analytically, the new ECB policy framework can be broken down into three main components. First, a higher and now explicitly symmetric inflation target of 2% instead of the confusing “below but close to 2%.” Second, an explicit tolerance for moderate inflation overshoots for a limited period of time that – in contrast to the Fed framework – will not be seen as contributing to the ECB’s inflation objective. Third, an explicit tolerance for overshoots near the ELB allowing for a more persistent and more forceful monetary policy response

While the new framework cannot undo past policy outcomes, it is already having an impact on the current policy stance, with potentially more material implications for future policy on interest rates and asset purchases. In late July, the ECB updated its forward guidance to reflect that policy rates will remain at present or lower levels until: 1) inflation durably reaches 2% well before the end of its projections (currently to December 2023); and 2) it judges that the realized progress in underlying inflation is sufficiently advanced to meet its commitment to greater persistence. In our view, this meaningfully reduces the risk of premature policy rate hikes by the ECB: as a result, we have pushed out our projection for a first rate increase and no longer expect a hike on a five-year horizon.

While the focus of the September meeting was on the quarterly decision on the pace of PEPP, we think the new inflation projections – still well below target – and the implications for the regular APP matter more. The APP is poised to take over as the main asset purchase vehicle once the PEPP concludes. The PEPP is supposed to run until March 2022 – the duration being determined by the assessment on the presence of a pandemic emergency and the pace determined by what the Governing Council deems necessary to ensure appropriate financing conditions in view of the inflation outlook.

Unanchored expectations
Forward pricing of U.S. and euro area inflation, 2010-2021

Chart showing U.S. and euro area forward inflation pricing

Forward-looking estimates may not come to pass. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, September 2021. Notes:  The chart shows the market pricing of five-year  inflation in five years’ time.  

New strategy taking effect

While the new framework cannot undo past policy outcomes, it is already having an impact on the current policy stance, with potentially more material implications for future policy on interest rates and asset purchases. In late July, the ECB updated its forward guidance to reflect that policy rates will remain at present or lower levels until: 1) inflation durably reaches 2% well before the end of its projections (currently to December 2023); and 2) it judges that the realized progress in underlying inflation is sufficiently advanced to meet its commitment to greater persistence. In our view, this meaningfully reduces the risk of premature policy rate hikes by the ECB: as a result, we have pushed out our projection for a first rate increase and no longer expect a hike on a five-year horizon.

The September meeting offered another chance for the ECB to communicate how the new framework will be implemented in practice, particularly when it comes to guidance on asset purchases. When the policy rate is close to the ELB, the ECB will explicitly tolerate a temporary overshoot of its inflation target, implying that policy support can be stronger than it otherwise would have been under the previous 2003 strategy framework. While the focus was on the quarterly decision on the pace of the pandemic emergency purchases (PEPP), we think the new inflation projections – still well below target – and the implications for the regular asset purchase program (APP) matter more. The APP is poised to take over as the main asset purchase vehicle once the PEPP concludes.

Leaning on the balance sheet
ECB asset purchase programs and monthly buying amounts, 2009-2021

Chart showing ECB asset purchases

Sources: BlackRock Investment Institute and ECB, with data from Haver Analytics, September 2021. Notes: The chart shows the evolution of the ECB’s different asset purchase programs since the GFC. The ECB’s purchases started with covered bonds (CBPP) and during the sovereign debt crisis briefly included government bond purchases under the Securities Markets Programme (SMP). In 2015, the ECB expanded purchases to government and supranational bonds (PSPP) and asset-backed securities (ABSPP), then in 2016 corporate bonds (CSPP). These all make up the overall Asset Purchase Programme (APP). 

Reinforcing the new nominal

Expectations will also play a key role in the future path of inflation. If the new target is viewed as more credible than the previous target in the light of the new framework and the broader macro backdrop, this will likely have the most powerful impact on future inflation. Simulations by ECB researchers from July 2021 suggest that the increase in realized inflation is likely to be larger than the increase in the objective itself because a higher target also eases the constraints caused by the ELB. When adjusting our economic projections for a different ECB reaction, we find that the new framework could result in a roughly 20-30 basis point rise in inflation and 30-40 basis point increase in GDP growth.

Yet it should be kept in mind that realized inflation stands at just 1.6% on average since inception of the ECB in June 1998, according to Eurostat data. That makes the ECB’s re-underwriting of an inflation target of 2% look somewhat ambitious despite the current post-pandemic inflation spurt – and in our view implies that it is probably not achievable through more persistent and more forceful monetary policy alone. Fiscal policy will likely need to provide additional limited support.

In sum, we believe the changes to the policy framework should result in lower real interest rates, further cementing our new nominal theme in the euro area by keeping nominal bond yields and real yields lower than they would have been in the past. At the same time, long-term bond yields will likely be marginally higher once the euro area reaches a new steady state due to the higher inflation objective. Even higher real yields would remain well in negative territory and thus be supportive of risk assets.

New nominal in action
German 10-year government nominal bond yield, inflation breakeven rate and real yield, 2011-2021

Chart showing the rebound in inflation breakeven rates for Germany

Past performance is not a reliable indicator of current or future results. Source: BlackRock Investment Institute, with data from Refinitiv Datastream, September 2021. Notes: The chart shows the breakdown of the German 10-year bund yield: the nominal yield is the difference between the inflation breakeven rate and the real yield.

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Elga Bartsch
Elga Bartsch
Head of Macro Research
Elga Bartsch, PhD, Managing Director, heads up economic and markets research at the Blackrock Investment Institute (BII). BII provides connectivity between BlackRock's ...
Jean Boivin
Jean Boivin
Head of BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is the Head of the BlackRock Investment Institute (BII). The institute leverages BlackRock’s expertise and produces proprietary ...

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