Faces dual test

At key meeting, ECB faces dual test of inflation and Omicron

The ECB keeps getting surprised by inflation, which has hit the highest level since the euro’s launch.

BY JOHANNA TREECK

The twin surge of inflation and COVID-19 infection rates will turn the European Central Bank’s Thursday meeting from the most important gathering since the launch of crisis measures to its most challenging.

The ECB is widely expected to announce it will end net bond purchases under its pandemic emergency purchase program (PEPP) by the end of March. There's a broad disagreement among ECB policymakers and watchers, however, on what quantitative easing after the pandemic should look like.

The central bank's communication recently has been "frustratingly unclear," wrote J.P. Morgan economist Greg Fuzesi. "This has reflected the increasing uncertainty policymakers have felt about the medium-term inflation outlook, even before the emergence of the Omicron variant."

The ECB keeps getting surprised by inflation — which has hit the highest level since the euro's launch — and is set to revise up its quarterly staff projections for the sixth consecutive time this Thursday. While analysts expect projections to be revised upwards for next year, possibly above the Bank's 2 percent target, most still see forecasts dropping back below target in 2023 and 2024.

ECB President Christine Lagarde, for her part, will likely point to the medium-term outlook to back up her long-standing claim that inflation remains a transitory phenomenon in the eurozone. Lagarde, along with her chief economist Philip Lane and other doves on the Governing Council, will also warn Omicron's emergence could pose downside risks to the recovery, meriting continued support from the ECB.

Yet even as the near-term growth outlook darkens, mounting risks inflation could continue to surprise on the upside are making it exceptionally hard to strike the right policy balance. Tightening policy too early could choke off the recovery — but moving too late could force a much sharper tightening, hurting growth prospects for years to come.

It's a similar dilemma for the Bank of England, which is met Wednesday and releasing its announcement Thursday. The Omicron surge has left most analysts expecting it will hold policy steady for now, despite fresh inflation data on Wednesday showing a 10-year high of 5.1 percent.

Another question for the ECB's Governing Council is whether Omicron might not only drag down growth but exacerbate inflation pressures, said Natixis economist Dirk Schumacher.

"Past experience suggests that lockdown measures are disinflationary in the short-run and inflationary in the medium-term," Schumacher said. "But the uncertainty surrounding this question is too high at this point to have any firm view on the inflationary implications. The latest developments would make it seem prudent to wait a bit longer before taking any decision."

Some ECB policymakers share that view and have suggested it may be better to delay finalizing the details of post-pandemic bond-buying until the policy meeting in February.

Lagarde, however, has said that she prefers offering at least some insights now without tying the ECB’s hands. "Otherwise, we just add uncertainty to uncertainty,” she told attendees at a Reuters Next conference earlier this month.

The waiting game

Any end of PEPP without temporarily boosting bond purchases under the ECB's older program, known as APP, or launching a new program risks market disruptions: It would see monthly asset purchases drop from around €80 billion a month now to €20 billion bought under the APP.

Even hawks on the Council have signaled a readiness to temporarily boost asset purchases under the APP to avoid so-called cliff effects.

Doves want to go a step further to ensure the ECB retains the same flexibility in bond purchases it currently enjoys under PEPP. These ideas include giving the Bank more leeway to adjust purchase volumes across quarters, as well as a more controversial proposal to let it focus bond buys on individual countries.

That would mark a departure from the APP, which requires the ECB to make purchases according to the size of member states’ economies.

The dilemma: Shifting the flexible tools of the PEPP onto the APP is almost guaranteed to spark new legal cases in Germany against ECB interventions. But removing the Bank's ability to focus purchases on an individual country could result in pushing up sharply the borrowing costs among most indebted countries.

As a case in point, the ECB has hoovered up all of Italy’s debt issuance since the start of PEPP to keep borrowing cost down, but investor concerns over the end of PEPP had sent the spreads of Italy’s 10-year bond over their safe-haven German equivalent rising to the highest level in over a year.

For now, most analysts expect the ECB to halve the amount of assets it buys each month from April and carry on buying €40 billion of bonds a month through the end of next year, with some forecasting ECB purchases through to mid-2023, according to a Reuters poll last week.

This strategy would also imply that rate hikes remain off the table until 2023, given the ECB is committed to keeping rates on hold until it phases out all asset purchases.

But whatever path the ECB takes, "it is likely that the decision will be contentious and the communication challenging for President Lagarde," warned Barclays economist Silvia Ardagna.

And policy announcements aside, it will be clear on Thursday that Europe isn't back to normal. Lagarde will keep an empty spot next to her during her press conference as a reminder that Vice President Luis de Guindos is currently isolating after being tested positive for COVID-19.