K shaped recoveries also require K shaped solutions. At least that is what the ECB would have you believe. But in a world of globalised capital where co-ordinated policy response is often the only tool to control the rush of money in and out of economies the ECB is making a bold stance in its policy decision by going against the swim of things.
The ECB has had a bond buying programme in place: a Euro 1.55 trillion pandemic emergency programme that is currently buying bonds (and adding liquidity) at the fastest pace since the programme was implemented. This is in contrast to the Federal Reserve’s debates whether to continue their buying bonds and securities at the rate of USD 120 billion per month or to taper the liquidity accretion as the economy picks up pace. The ECB are continuing with their ultra-loose monetary stimulus directly contrary to not just the Fed but also numerous other central banks which have started tightening liquidity and/or rates.
On the face of it this is very strange behaviour. If you look at the data coming out of Europe it looks like the ECB might want to get in line with the other central banks. Confidence in the Euro-zone area economies are at their highest levels in more than two decades. With the fall in infection rates and the pandemic restrictions being lifted subsequently there is an expectation all round of a growth of travel and business activity resumption. And, barring Spain, confidence indicators in 5 of the 6 largest European economies for June are all up. Consumer sentiment is also up for the 5th month in a row, the expectation of employment growth also rose and there is optimism in the hiring plans for industry and services. A lot of this is, of course, due to the euphoria over re-opening. But still…
The rest of the world is looking to raise rates or have already done so. The UK, Canada, Norway, Sweden, South Korea, New Zealand are all thinking about starting the reversal of policies designed for the emergency conditions of the pandemic. Mexico, Hungary, the Czech Republic have just raised rates whilst Russia, Brazil and Turkey have raised them earlier. Only India seems to be still talking a soft stance game. In Germany even the Bundesbank President Jens Weidmann has suggested that the risks to the upside now ‘predominate’. So- again, why has the ECB decided to continue their contrarian stand?
Well, the starting point for comparison is different. Both the Fed and the ECB have 2% inflation targets. But the US’s latest inflation print came in at a surprisingly high 5% (see earlier article) whereas the EU-wide number climbed to touch a 2 ½ year high of 2% before again tailing off again to 1.9% this month. Even CPI in Germany has fallen to 2.1% from the previous month’s reading of 2.4%. The ECB, in conjunction with the Bundesbank, have also stated that they believe that the spike was temporary. This suggests that the EU is in a different space than the US entirely. The US inflation number may be a temporary surge itself but the European surge from their optimism has just taken them up to their long-term target rate. And, going by what the ECB and Bundesbank are saying, this may be a temporary spike. Essentially, the EU is in a much more fragile state than the leading indicators suggest.
Indeed, the ECB is trying to emphasise the variance in recovery stages and inflation risks between the US and themselves. They want the market to price their securities differently than they do for the US for price normalisation, the timing of the end of QE or even for future rate rises. So, while the Fed is already talking about tapering and the timing of their first rate hike in 2022 the market is already pricing in a 10 basis point hike in 2023 for Europe and yields are elevated. The ECB is trying to put a circuit breaker to this mindset. This is the main reason for the bond purchase volume hike by the ECB: they aren’t ready for a rise in rates. More specifically, they don’t believe that the European economies are ready for the transmission of higher interest rates at the moment. This is why they are signalling their intentions clearly.
The indicators that are signalling positivity are still just leading sentiment indicators. The European Commission sentiment index rose to 117.9- exceeding expectations signalling a solid mood swing in services with retail/ industry and even construction sentiment up. But these are still not hard numbers. The ECB Chief Economist Philip Lane has stated that there is as yet insufficient data to support the firmness of recovery and so the elevated pace of stimulus will be required for longer. The end of the ECB bond buying programme has a hard stop at any rate: May 2022. At the moment it is felt that the ECB needs to signal their intentions to the market rather than the letting the market dictate the narrative.
Even though Europe wide inflation is expected to hit 2.5% by the end of the year it is still below the run rate now. The overshooting of inflation is not feared as much as a stalled economy where unemployment keeps rising. Unemployment rates had been declining secularly since 2013 from 12% down to 7% just before the pandemic struck. Even with generous furlough packages for employers to retain their non-working staff unemployment still shot up to 8.7% in August/September last year. They have brought it down to 8% and do not want to risk the longer-term downward trend in this indicator. The dependence on the speed of private sector in hiring is critical and the ECB feels this segment to be vulnerable- particularly given the susceptibility of the tourism sector to any resurgence of the pandemic. Europe may be going against the world’s trends but they are in tune with their own needs.