ECB’s de Cos: If HICP Forecast Doesn’t Rise With Market Rates, ECB Should Act

23 April 2021

By David Barwick – FRANKFURT (Econostream) – When a rise in market rates is not accompanied by a return of the European Central Bank’s medium-term inflation forecast to what it was before the pandemic, then the Governing Council should mitigate that rise with its pandemic emergency purchase programme (PEPP), Council member Pablo Hernández de Cos said Friday.

In a speech at the Ernst and Young Insights Forum posted to the website of Banco de España, which he heads, de Cos said that decisions about the pace of PEPP purchases would be taken without regard to the preceding pace.

The outlook for HICP at the horizon of the staff projections ‘is the key criterion that allows us to judge whether a tightening in financing conditions is inconsistent with countering the negative impact of the pandemic on inflation’, he said. ‘To the extent that an increase in interest rates is not accompanied by a return of the medium-term inflation projection back to its pre-pandemic level, PEPP purchases should be adjusted in order to counter such increase in interest rates.’

At its meeting yesterday, the Governing Council ‘broadly’ confirmed previous macro projections, found the balance of risks to be ‘largely’ as before, and considered financing conditions to have remained ‘broadly’ stable, he said. However, it also saw that ‘risks to wider financing conditions remain’ and thus ‘decided to reconfirm its very accommodative monetary policy stance’, including a faster rate of PEPP purchases over 2Q, he said.

‘Thus, within this framework the pace of purchases under PEPP is determined considering current- and forward-looking, not backward-looking, indicators’, he said, meaning ‘the present state of financing conditions benchmarked against the future expected path of inflation.’

‘And, therefore, the past pace of purchases are by no means a conditioning factor in the PEPP pace decision-making’, he added. Though the PEPP envelope need not be depleted if financing conditions do not warrant it, it can also be ‘recalibrated and upscaled’, he said.

A real euro area yield curve can be constructed by subtracting inflation-linked swap rates from the nominal yield curve, he said.

‘In my view, as long as our medium-term inflation projections do not show a clear improvement, with a view to assisting the recovery in economic activity and hence in the inflation outlook, we should accommodate increases in market-based long-term inflation expectations measures in order to ensure that they translate into lower long-term real interest rates’, he said.

Notwithstanding the unremitting dovishness of his policy prescription, de Cos predicted ‘a firm rebound in economic activity that should become more clearly visible in the second half of this year’ and listed reasons for ‘a more positive international scenario’, namely stronger-than-expected growth in 4Q, the trade agreement with the UK and generous fiscal measures elsewhere.

Euro area economic output would top its pre-pandemic level in 2Q of next year, he said, ‘one quarter earlier than projected in December.’ ECB President Christine Lagarde on Thursday had said that ‘the euro area economies will return on average to the pre-pandemic economic level in the second half of 2022.’

Still, ‘although medium-term risks remain more balanced, uncertainties over the near term continue to be tilted on the downside’, he said.

As for the ECB’s assessment of inflation, ‘[i]t is worth emphasising that the recent behaviour of alternative indicators of inflation expectations does not contradict this’, he said. ‘Although market-based indicators of inflation expectations have been on the rise, they remain far from the target for long-term horizons.’

These indicators also contain ‘sizeable and volatile inflation risk premia’, he added.