ECB’s Schnabel: ‘Investors Have Started Internalising Our More Patient Reaction Function’

15 September 2021

By David Barwick – FRANKFURT (Econostream) – Financial markets have taken the European Central Bank’s new forward guidance on board and understand that the ECB will be more patient before altering its monetary policy stance, Executive Board member Isabel Schnabel said on Wednesday.

In a speech at the Bond Market Contact Group meeting posted to the ECB’s website, Schnabel called the decline of US and euro area sovereign bond yields over the summer despite economic recovery, higher inflation and the pending reduction of monetary policy support ‘remarkable’.

Nominal overnight index swap (OIS) rates in the euro area have been boosted by market-based measures of inflation compensation, which ‘seem to suggest that investors see the recovery from the crisis as an opportunity to escape the low inflation environment that has dominated the macroeconomic landscape for many years’, she said.

However, lower real interest rates have ‘offset a large part of the rise in nominal yields that would have resulted from higher inflation expectations’, she said.

This stands in contrast to the increase of real long-term yields that would be expected to occur in tandem with economic recovery, she noted, especially given massive fiscal and monetary support. That such an increase has not happened could mean that markets expect secular stagnation, or that other factors are at work, she said.

One possibility is that markets are too worried about the Delta variant’s potential to suppress global growth, she said. While the variant has had the effect of a supply-side shock, ‘market analysts’ growth expectations suggest that this shock is widely perceived as being short-lived’, implying that to the extent the lower real yields are due to worries about growth, this means ‘a decoupling between sovereign bond market pricing on the one hand and stock markets’ and analysts’ growth expectations on the other.’

Another possible explanation is that asset purchases by central banks have supported real rates in the euro area and the US, she said. Although markets increasingly expect these purchases to be scaled back, ‘ECB simulations show that our joint asset purchase programme (APP) and PEPP holdings can be expected to put sizeable downward pressure on interest rates across the maturity spectrum even in three to five years’ time’, she said.

Alternatively, there may be ‘a perceived change in the reaction functions of central banks, largely reflecting recent adjustments to strategic frameworks’, she said, citing changes in the correlation between future interest rates and inflation expectations as evidence that ‘markets expect less monetary policy tightening for each incremental improvement in the medium-term inflation outlook.’

This may reflect markets’ incorporation of new ECB forward guidance, she said, reminding of the Governing Council’s conditions of ‘reaching 2% well ahead of the end of our projection horizon’ remaining at 2% thereafter, and of actual progress in underlying inflation being ‘sufficiently advanced to be consistent with inflation stabilising at 2% over the medium term.’

‘In other words, given the significant uncertainty surrounding inflation projections many years out, we want to see clearer signs that inflation is reliably moving towards our 2% target’, she said. ‘This will imply a more patient reaction function … and hence may also imply a transitory period in which inflation is moderately above target.’

Schnabel argued that changes in the distribution of risks around future interest rate prospects, as seen with respect to the future evolution of the 3-month Euribor, and around future inflation prospects, as seen by the inflation risk premium in the euro area bond market, ‘corroborate the view that investors have started internalising our more patient reaction function.’

‘Yet, despite growing upside risks, the sensitivity of rate expectations to changes in the inflation outlook has not changed’, she said. ‘This suggests that investors have understood that higher inflation prospects will need to visibly migrate to the baseline scenario and be reflected in actual underlying inflation dynamics before they warrant a more fundamental reassessment of the medium-term inflation outlook, and hence the future course of monetary policy.’