ECB Meeting to Highlight Division Among Governing Council Members

9 March, 2021

By David Barwick – FRANKFURT (Econostream) – The European Central Bank faces a monetary policy meeting of the Governing Council on Thursday that may bring the differing views among its members into starker relief than any other such gathering recently.

For most of the crisis triggered by the pandemic, the need for the ECB to act decisively was widely accepted by euro area central bankers regardless of philosophical orientation, and the undeniable economic and medical devastation wrought by the outbreak largely paved over differences.

Even Bundesbank head Jens Weidmann, the most prominent hawk on the Governing Council, only last week reaffirmed that ‘it was correct to act boldly in the crisis’, calling the pandemic ‘undoubtedly just such an exceptional situation’ in which even large-scale purchases by the Eurosystem of government bonds was warranted.

To be sure, it was always clear that there was a range of views, with some Council members apparently ever ready to open the monetary floodgates yet more widely and others more inclined to stress the eventual need to unwind all the measures taken. Executive Board member Fabio Panetta is hardly the least vocal representative of the former faction, and the recent rise in long-term yields has his camp alarmed.

So it is that Panetta, on the premise that the financing conditions prevailing in December constitute the correct degree of favourability, last week asserted that ‘the steepening in the nominal GDP-weighted yield curve we have been seeing is unwelcome and must be resisted.’ The ECB ‘should not hesitate to increase the volume of purchases and to spend the entire PEPP envelope or more if needed.’

Panetta’s implicit call for yield curve control – which he called ‘anchoring key financial variables – above all, lending rates and the yield curve’ - could elicit some support. Bank of Spain Governor Pablo Hernandez de Cos last week said that with inflation expectations not having kept pace, the rise in nominal yields could negatively affect inflation. The ECB ‘will need to monitor nominal long-term interest rates closely and act appropriately to maintain favourable financing conditions’.

Panetta and de Cos have tended to be at the forefront of those agitating for more policy action. But previous grist for their mill – whether the appreciation of the euro or the public health situation – was different. It is reasonable to assume that the rise in yields is to some extent a reflection of risen optimism. Risen optimism, even before being borne out - or not - by developments, can not only manifest in such a way as to undercut monetary policy, but could also undermine current notions about how long monetary accommodation will or should remain available. The thought of withdrawal would understandably alarm the most vulnerable Eurozone member countries.

In a speech at the end of last month, Panetta’s Executive Board colleague Isabel Schnabel said that ‘a rise in nominal yields that reflects an increase in inflation expectations is a welcome sign that the policy measures are bearing fruit. Even gradual increases in real yields may not necessarily be a cause of concern if they reflect improving growth prospects.’

‘However’, she continued, ‘a rise in real long-term rates at the early stages of the recovery, even if reflecting improved growth prospects, may withdraw vital policy support too early and too abruptly given the still fragile state of the economy.’

Although the short-term outlook has taken a hit from the ongoing policy response to the pandemic’s evolution, there are indications that further out, things could pick up again with less delay. Last week, Dutch National Bank President Klaas Knot suggested that this is the essence of the current situation, calling higher yields a ‘positive story’ given that ‘[w]hat the market is actually doing is pricing that optimism’ about future economic developments.

Striking a similar note one day previously, Weidmann said that an improvement in underlying fundamentals or the economic outlook would also boost real interest rates, but ‘would be a development that would be less problematic than others.’

The ECB must thus in any case take a close look at recent developments and determine whether they are something to be ‘resisted’ or are instead ‘less problematic’. That implies a need for greater clarity about the financing conditions it wishes to preserve and under what circumstances it feels compelled to react.

To the extent the ECB addresses these questions in a thorough, credible and well-communicated manner, it may see itself as less obliged to take any other steps. However, monetary authorities could well decide that a somewhat more robust response is appropriate, lest markets decide to test them.

Yield control is however unlikely to be the choice anytime soon, let alone this week, given the reluctance of even some dovish Council members to go that route. ECB Vice President Luis de Guindos has thrown cold water on the notion of a shift to such a regime, while Bank of Portugal Governor Mario Centeno recently appeared to dismiss yield curve control as not ‘the easiest way forward’ and ECB Chief Economist Philip Lane called it ‘crystal clear that we are not engaged in yield curve control.’

A scant three months after the recalibration of the ECB’s policy measures, it is also a bit soon for more of that. Still, it can’t be ruled out – de Guindos last week said that the ECB would ‘have to see whether this increase in nominal yields will have a negative impact on financing conditions’, but that if so, ‘then we are totally open’ to another recalibration including an increase in the PEPP envelope. But he did not sound eager for such a move, stressing it was an option ‘if necessary’ and pointing out in the same breath the ‘good news’ that spreads had not increased.

The need for a more robust response than verbal intervention thus seems most likely to be filled by an accelerated deployment of the PEPP, which many observers have already looked for in vain. Frontloading purchases would probably garner broad support while being the least objectionable compromise Council hawks can reasonably hope for.

Bank of France Governor François Villeroy de Galhau, while sharing the view held by his fellow doves that the ECB ‘can and must react to counter’ the ‘unjustified’ tightening of rising yields, already said that the starting point of a reaction would be ‘making our purchases under the PEPP with active flexibility’. And Weidmann, though declining to see the need, also indicated that the PEPP would be the first port of call if there were a need, saying, ‘It’s precisely for this that we have flexibility’.

As to the staff macroeconomic forecasts to be updated on Thursday, an increase in the inflation projection for this year is a given. De Guindos last week said that inflation for all of 2021 would be  ‘above 1% on average’, versus the December staff projections calling for exactly 1.0%. Given how little it would have cost him to say ‘slightly’ above 1%, a more significant upward revision appears to be in the offing, which is also in line with observers’ expectations of closer to 1.4% for the year.

As for 2022 and 2023, de Guindos was a good deal less specific than just one short week previously, when he had insisted that ‘[w]hat we’re seeing now is not a significant and persistent change in the path of inflation.’ Still, in a highly uncertain environment it remains early for substantial modifications to the medium-term outlook.