ECB: The ECB amps up PEPP purchases to check yield rise

• The ECB will step up purchases under the PEPP program during the next quarter The central bank’s immediate focus is on keeping financial conditions favourable
• The staff projections for GDP growth have been maintained broadly unchanged which do not incorporate yet the latest US stimulus package
• We consider that the PEPP envelope is large enough to comfortably increase purchases over the next quarter without the ECB having to increase the PEPP envelope

The ECB, as expected, left its key benchmark interest rates and broader policy guidance unchanged today, but surprised boldly by announcing a significant step up of asset purchases under the PEPP program next quarter, as compared to that in the first months of the year. The consensus driven decision was a clear response to the recent undesirable increase in Euro Area bond yields, led, in part, by higher inflation expectations in the US.

Elaborating on the new move, the ECB chief, Lagarde, made clear that it was not any kind of yield curve control. She refused to quantify the monthly increase in PEPP purchases. Furthermore, she tempered expectations of an immediate significant increase in PEPP purchases on a weekly basis, stating that the ECB preferred a longer, quarterly horizon, to assess changes in its PEPP purchases. In essence, the ECB would assess the favorability of financing conditions (the “compass”) by looking, on a quarterly basis, at inflation (the anchor), so as to determine the magnitude of increase in PEPP purchases. Echoing ECB’s Chief Economist, Philip Lane’s, recent rhetoric, Lagarde emphasised the role of a holistic and multifaceted approach towards assessing financial conditions, which would involve looking at several upstream and downstream indicators, rather than based on a single aggregate synthetic measure.

On the state of the economy, the ECB expects Euro Area real GDP growth to contract again in the current quarter in the wake of continued economic weakness driven by the persistence of pandemic and associated containment measures. That said, gradual relaxation of containment measures and vaccination alongside favorable financial conditions and expansionary fiscal stance and demand recovery are expected to aid economic recovery over the course of this year. In this context, ECB’s updated macroeconomic forecasts suggest that risks have become more balanced, although they remain tilted to the downside in the near term as mutations and the vaccine rollout continue to be a large source of uncertainty. The new lockdown measures have proved to have a lower negative impact on the economy due to learning effects, as it was reflected in the better-than-expected data for 4Q20. Still, as containment measures were extended in early this year, a new decline in activity of -0.4% QoQ is projected for 1Q21, followed by a stronger recovery as vaccinations ramp up. In general, macroeconomic projections remain broadly unchanged, with a growth of 4% in 2021 (previously 3.9%) and 4.1% in 2022 (previously 4.2%), while reaching the pre-crisis levels in the second quarter of 2022, one quarter earlier than previously expected. For 2023, growth will moderate to 2.1%. Meanwhile, inflation has picked up on account of transitory and technical factors along with increasing energy prices, but inflationary pressures remain subdued due to weak demand and significant slack in labor. As a consequence, inflation has been revised upwards for 2021 to 1.5%, and it is expected to peak at 2% in the last quarter of the year, but they will look through that as it will only be temporary. From there on, it is still forecasted to remain well below its target, at 1.2% in 2022 and 1.4% in 2023. Crucially, these forecasts do not incorporate, yet, the latest US stimulus package (which put an upward bias to both growth and inflation and will be taken into account in June’s forecasts), although the Staff estimates that it will have a mild impact on the Eurozone  economy, with a 0.3pp increase in real GDP and a 0.15pp in inflation over the forecast horizon. Overall, this outlook reflects a very accommodative monetary and fiscal stance, with Mrs. Lagarde highlighting the importance of the NGEU and the recent extension of fiscal waivers until 2023, while the Stability and Growth Pact should be reviewed once the pandemic is over, to make it simpler among other reforms. Finally, the ECB also reiterated that it will monitor carefully the development of the Euro exchange rate given its impact on outlook for price stability and its impact oneconomic activity.

All said, in our view, in the face of recent volatility and upward moves in long rates, the ECB wants to ensure, with today’s announcement, a calmer situation over the next three months, which, in effect, would still be a difficult period for Europe in terms of both, the pandemic induced growth risks and the lingering doubts over inflation outlook. We consider that the PEPP envelope is large enough to comfortably increase purchases over the next quarter without the ECB having to increase the amount of the program before March 2022. The ECB has so far spent €0.9 trillion ofthe 1.85 trn earmarked under PEPP.