ECB to Maintain Record Low Rates Until Reaching Updated Inflation Target at 2%

The European Central Bank (ECB) presented its monetary policy statement on July 22. The central bank has maintained its interest rate at 0.00% during the pandemic to support the economy. During its latest meeting, it pledged to keep the record low levels for longer than anticipated, as the bank wants to reach and consolidate its new inflation target of 2% and noted that the Delta variant posed a considerable risk to the economic recovery.

All in all, the ECB’s tone was dovish. The euro has been quite volatile following the central bank’s statement, with EUR/USD declining from 1.1811 during the statement to a low of 1.1771 shortly after it. However, the pair then suddenly bounced back after the ECB’s press conference, hitting a daily peak at 1.1831. The truth is that the latest spike had to do with a weakening dollar rather than a strengthening euro. Specifically, the US jobless claims data released earlier on Thursday put additional pressure on the US dollar. Nevertheless, the disappointment in the ECB’s statement eventually prevailed, with the euro finally giving up by the end of the day to decline to the current level of 1.1760, which happens to be a resilient support level. If it can’t hold it, the price might drop further to update the lowest level since April near 1.1750.

ECB’s Decision Reflects New Strategy

At the beginning of July, the ECB introduced a new monetary policy strategy, which is the first strategy review since 2003. The monetary policy strategy review was launched in January, and its outcome was presented on July 8. It touches upon various components of the eurozone’s economy, getting deeper into factors that influence price stability, along with issues like employment, climate change, and social inclusion. The new strategy adopts a symmetric 2% inflation target over the medium term, which is slightly higher than the previous target of keeping inflation close to 2% but just below it.

The latest statement released on July 22 was in line with the new strategy, which is why the ECB revised its guidance on interest rates changes to tell investors that it would continue to support the economy until reaching the inflation target. However, ECB President Christine Lagarde admitted that the change in guidance wasn’t supported by all policymakers, though it was backed by an “overwhelming majority.”

https://twitter.com/ecb/status/1418204659001356289

Even if inflation reaches the target for a short period, the bank won’t be in a hurry to enforce a tighter policy. Basically, the next rate hike is years away since the ECB is expecting inflation to be at only 1.4% in 2023.

Still, Lagarde said that she wouldn’t “anticipate what our inflation forecast will be next year and the year after. We know well that forecasting is a tricky game, well not a game actually but a tricky exercise.”

Bond Buying Continues at Increased Pace

Besides not touching the interest rates, the ECB said it would continue purchasing bonds at a higher rate over the next two months, reiterating its plan to stay away from tightening the monetary policy following a surge in inflation in the first half of 2021. It made very clear that it wouldn’t raise rates until inflation consolidates above the target level.

Meanwhile, markets are not really impressed with the announcement. For example, the bond markets regard the new guidance as a significant reduction of the unprecedented liquidity support for the economy.

Arne Petimezas, an analyst at AFS Group, stated

The problem with the ECB statement is that it has no teeth. I get it that they want higher inflation and they’re more tolerant to inflation. But they’re not willing to do more to reach their goal, except promises of easy policy for longer.

At the moment, the ECB is buying bonds through its two main programs:

  • Asset Purchase Program (APP) – the ECB said that net purchases under the APP would go on at a monthly pace of 20 billion euro. The bank’s Governing Council expects the monthly bond buying under the APP to continue for as long as needed to reinforce the accommodative effect of its policy. It expects the APP to end shortly before the central bank starts raising the interest rates.

  • Pandemic Emergency Purchase Program (PEPP) – under the PEPP, the ECB will continue the net asset purchases with a total envelope of 1.85 trillion euro until at least the end of March next year. The deadline may be extended if the central bank judges that the pandemic is not over.

Economy Keeps Recovering But Risks Persist

In a joint statement from the ECB President Christine Lagarde and ECB Vice-President Luis de Guindos, the ECB said that the recovery was on track, as increasingly more people get one of the approved vaccines against COVID-19. However, the pandemic still casts a shadow, as the Delta variant causes serious concerns.

Consumer spending is rising as people return to shops and restaurants. Spending is also reinforced by better employment prospects, increasing confidence, and government support.

We expect economic activity to return to pre-crisis level in the first quarter of next year. But there is still a long way to go before the damage to the economy caused by the pandemic is offset,” the ECB noted.

The number of people in job retention schemes has dropped but remains high, and there are still 3.3 million fewer people employed compared to the period before the pandemic.

The ECB said that the recent spike in inflation was temporary and that outlook for inflation over the medium term remained subdued. The price growth will accelerate over the coming months, but it will slow down again in 2022. The latest increase was driven by higher energy prices and the impact of the temporary VAT cut in Germany last year.

In conclusion, the central bank observes a rapid economic recovery, but the outlook depends on the course of the COVID pandemic and progress with vaccinations. Despite the visible rebound, the ECB will maintain its bond-buying programs at the current pace until reaching the new inflation target of 2%.

Expert Commentary

While the European currency has lost some ground following the ECB meeting, most investors and analysts have had a moderate reaction so far. Here are some of the comments made by experts:

Holger Schmiedling, Chief Economist at Berenberg:

“The ECB currently projects 1.4% inflation for 2023 and seems to expect only modest upward pressures on inflation on trend. Taken at face value, the statement suggests that the ECB may only raise rates in 2025 if the ECB were then to project a rise of inflation to at least 2% by mid-2027.”

Elga Bartsch, head of Macro Research at Blackrock Investment Institute:

“Today’s dovish move, which will likely be followed by an upward adjustment in QE later this year, was enabled by the ECB’s new strategy framework unveiled on July 12. It has been made possible because, contrary to the strategy framework itself, which was agreed unanimously, the policy decisions themselves do not need to be taken by consensus.”

Konstantin Veit, portfolio manager at PIMCO:

“Similar to the Bank of Japan’s inflation overshooting commitment, the ECB’s reference to transitory overshoots probably won’t durably impress markets given the long history of missing the previous, more conservative definition of price stability. In September, we believe the ECB will start to prepare for an end of PEPP and an upsize of the regular APP in 2022, to maintain easy financing conditions beyond the end of the pandemic emergency policy measures, as progress towards the inflation objective remains inadequate.”

Share this post on:

Share on reddit
Share on facebook
Share on twitter

More Articles

Here are some other articles you might enjoy: