ECB Meeting Account Confirms Preoccupation With Inflation and Differing Views

25 November 2021

By David Barwick – FRANKFURT (Econostream) – The account of the European Central Bank’s policy meeting of 27-28 October, released by the ECB on Thursday, confirmed the preoccupation among Governing Council members with inflation and made clear that opinion differed, even if the general view was of an improved medium-term outlook.

An accommodative policy stance should be reconfirmed as appropriate and consistent with the need for persistence expressed in the ECB’s forward guidance, it was ‘widely’ felt, though someone remarked that ‘at some point in the future, the very generous monetary policy support to the economy would need to be reassessed in view of the improved inflation outlook and be brought towards a more neutral configuration over time.’

All Council members agreed that pandemic emergency purchase programme (PEPP) purchases should continue at a moderately lower pace in 4Q than in 1Q and 2Q, and also confirmed all other measures, the account said.

According to the account, ‘the view was held’ that net PEPP purchases could end ‘by March 2022’, although ‘it was highlighted’ that decisions needed to be made on the basis of available information and the account seemed to imply that this particular decision was meant for December.

‘While the Governing Council would benefit from new staff macroeconomic projections at its December meeting, it was cautioned that the data available in December would not resolve all the uncertainties around the medium-term inflation outlook’, the account said. ‘It was seen as important that the Governing Council should keep sufficient optionality to allow for future monetary policy actions, including beyond its December meeting.’

There were ‘concerns’ in connection with market participants’ potential failure to understand the ECB’s conditions for a rate hike, the account revealed. While it was seen as possible ‘that market participants judged that the interest rate lift-off conditions would be met earlier than the Governing Council anticipated’, a competing interpretation was that ‘market participants were possibly questioning the credibility of the Governing Council’s forward guidance.’

‘Overall, it was acknowledged that the medium-term inflation outlook had improved’, the account reported. At the same time, ‘it was deemed important for the Governing Council to avoid an overreaction as well as unwarranted inaction, and to keep sufficient optionality in calibrating its monetary policy measures to address all inflation scenarios that might unfold.’

Chief Economist Philip Lane’s assessment of inflation - as subject to near-term further increases before declining over 2022 as the various drivers of higher prices eased or disappeared from annual HICP - was ‘broadly’ shared by meeting participants.

The continuation of the recovery with a return to full capacity was seen supporting wages ‘over time.’ Notice was taken of the move towards 2% by market- and survey-based indicators of longer-term inflation expectations and of options markets’ exclusion of low-inflation outcome over the next five years.

‘Reference was made to the recurrent underestimation of the latest outcomes for both headline and underlying inflation, corroborating earlier conjectures that the risks around the September 2021 ECB staff projections had been tilted to the upside’, the account said. ‘Against this background, it was seen as likely that in the December 2021 Eurosystem staff projections the shorter-term inflation outlook for the euro area would once again be revised upwards.’

At least one person suggested keeping an ‘open mind’ about how inflation developments would ultimately play out. ‘Looking beyond mechanical updates, it was stressed that more persistent bottlenecks and the increases in energy costs could have repercussions that would ultimately have a dampening effect on underlying inflation and therefore on the medium-term inflation outlook’, the account said.

‘Members considered’ that higher medium-term inflation needed higher wage growth and expectations, with at least one person arguing that wage growth should be a persistent increase in the rate of growth and not simply a change in the wage level.

Second-round effects had not yet been observed, it was ‘widely’ agreed, but it was also noted that wage agreements in the context of higher inflation were mostly yet to come, so that ‘[s]econd-round effects might thus still be observed after some delay and it would only be possible to identify them once the next round of wage negotiations had been completed.’

One or more members argued that some catch-up of wages was to be expected and that higher wages due to tighter labour markets would be healthy.

The discussion, clearly protracted, touched on the fact that higher carbon prices were not reflected in the projections, but whether more expensive energy would ultimately support activity and inflation apparently remained an open question.

‘Related to this, doubts were expressed about the use of typically downward-sloping oil price futures curves as projection assumptions, when fossil fuel prices were bound to remain elevated or rise further’, the account reported.

The 4.5% growth rate of owner-occupied housing costs reached in 2Q 2021 was ‘a source of concern’, though ‘it was cautioned that this supplementary cost indicator should not always be expected to make a positive contribution to inflation,’ the account said.

The mean reversion of models used for the staff forecasts came in for criticism, according to the account.

With respect to inflation expectations, these ‘were now seen as being close to or having already reached the 2% target; though ‘[i]t was pointed out that this was only a gradual move towards levels more in line with the new inflation target and that such re-anchoring should not be confused with an unanchoring on the upside.’

Council members agreed with Lane about the euro area economic outlook and risks and that inflation would mount further in the short term but then subside in 2022. They also accepted the view ‘of a solid global recovery although with some slowing of momentum’, while some concern was raised about how global uncertainty would affect foreign demand.

‘Members widely acknowledged that supply bottlenecks were lasting longer than initially thought’, and the idea of a reversal of past globalisation was expressed. ‘Overall, however, it was stressed that supply bottlenecks would gradually fade away as supply reconnected with demand, even though this was taking longer than expected’, the account said.

Economic risks were seen as broadly balanced, with more expensive energy and supply constraints harbouring the potential to restrain the recovery.

‘At the same time, if persistent bottlenecks were to feed through into higher than anticipated wage rises, or if the economy returned more quickly to full capacity, price pressures could become stronger’, the account said. ‘However, economic activity could outperform expectations if consumers became more confident and saved less than currently expected.’

Stagflation was not seen as a high-risk scenario. ‘It was quite normal for the latter stages of a recovery to be accompanied by lower growth, and most of the recent upward pressure on prices was coming from base effects’, the account said. ‘It was stressed that the current outlook clearly lacked the stagnation element.’

Higher long-term rates were seen as indicative of changed views of inflation in the wake of risen energy prices and stubborn supply constraints. Market participants were evidently more worried that inflation would surprise to the upside even after the effect of the shocks had passed, the account said.

The one-year swap rate three years ahead indicated medium-term inflation expectations of 1.99% going into the Council meeting, and thus at the highest level in almost nine years, the account said. ‘Over the next five years, inflation was expected to be visibly above the Governing Council’s target of 2% on average’, it said.

Still, the ECB’s forward guidance was seen as remaining credible, taking into account its state-contingency, based on inflation swap rates and forward OIS rates, according to the account.

‘Developments in euro area credit and stock markets suggested that higher nominal long-term yields and the prevailing supply shocks were not expected to derail the recovery’, according to the account.