English (India)

Lagarde speech shows ECB not even thinking about any policy tightening despite surging inflation

calendar 21/11/2021 - 20:59 UTC

EURUSD made a panic low around 1.12500 early U.S. session Friday, plunged to a 16-month low on the concern of renewed COVID lockdown and dovish ECB talks. EURUSD slips after dovish talks from ECB President Lagarde, who said it does not make sense to tighten policy as inflation pressure in the Eurozone is expected to fade in the medium term. The ECB President also indicated the continuation of the PEPP in some other calibrated form after Mar’22, to support the recovery and the sustainable return of inflation to the target of 2%. In brief, ECB is not ready to hike in 2022 and may only taper the pace of PEPP after Mar’22 instead of a complete halt. Overall, ECB's credibility over price stability mandates is now at stake.

Commitment and persistence: monetary policy in the economic recovery

Keynote speech by Christine Lagarde, President of the ECB, at the 31st Frankfurt European Banking Congress 2021 “From Recovery to Strength”

·         COVID crisis may have eased, but not over

“Today’s conference focuses on adapting to the challenges of the post-pandemic world, which is crucial to ensuring that our economies can emerge from this crisis stronger. But as much as we need to look to the future, we still have hurdles to overcome in the present”.

·         Elevated inflation is a result of higher pent-up demand as the economy is reopening coupled with supply bottlenecks and surging energy/oil prices. Inflation may be elevated till at least Dec’21

“We are still in a phase where the economy is reopening and the effects of the pandemic have not yet fully played out. In particular, rising energy prices, supply bottlenecks, and the withdrawal of physical distancing measures are causing considerable frictions in some sectors. This is being reflected in high inflation rates, which are likely to increase further until the end of the year.”

·         The elevated inflation is unwelcome and painful, especially for lower-income people; ECB is not sure how long will such hot inflation will last, but is actively and seriously monitoring the development

“This inflation is unwelcome and painful – and there are naturally concerns about how long it will last. We take those concerns very seriously and monitor developments carefully. In particular, we recognize that higher inflation squeezes people’s real incomes, especially those at the bottom of the income distribution”.

·         ECB still thinks that drivers of hotter inflation are elevated energy prices and supply chain disruptions, which should fade over the medium term, but at the same time, these transitory issues may also slow the economic recovery in the near term

“But to understand what monetary policy should do in the current circumstances, we have to identify the underlying drivers of inflation. Today, I will argue that those drivers are likely to fade over the medium term, which is the horizon that matters for monetary policy. And, because they largely stem from the supply side and energy prices, they will probably slow the pace of the recovery in the near term.”

Our recent strategy review provides us with a playbook for how to act in such a situation.

·         ECB must not rush into a premature tightening under such supply-driven inflation shocks, which may fade over the medium term; ECB should keep rates at lower bound so that inflation hits 2% symmetrical target on a durable basis; i.e. ECB should be patient, but should be committed to achieving the 2% inflation target

“Our review confirmed that we see negative and positive deviations from our 2% inflation target as equally undesirable. But for inflation to return sustainably to target when interest rates are near the effective lower bound, we need to be persistent in our monetary policy. In particular, we must not rush into a premature tightening when faced with passing or supply-driven inflation shocks. In the words of Abraham Lincoln, ‘commitment is what transforms a promise into a reality – and this is the spirit we need to ensure that we reach our 2% target on a durable basis.”

·         As the real purchasing power is already squeezed due to higher inflation, especially elevated energy & fuel bills, ECB will not go for any pre-mature tightening, which may further delay economic recovery. ECB will nature growing demand for the near term as medium-term inflation outlook in line with ECB’s price stability objective

“At a time when purchasing power is already being squeezed by higher energy and fuel bills, an undue tightening would represent an unwarranted headwind for the recovery. However, as positive demand forces in the economy gain strength, the inflation outlook over the medium term is looking better than it did before the pandemic. So, we should continue nurturing these forces by not withdrawing policy support prematurely.”

Current drivers of inflation in the euro area

What are the drivers of inflation in the euro area today?

·         ECB thinks the main drivers of inflation are surging energy prices and lower base effects coupled with higher pent-up demand and lower supply. Although core inflation surged in recent times, the extent is much less than in the U.S.

“To begin with, there is still some inflation that is purely “mechanical” and results from base effects. Inflation fell dramatically last year during the lockdowns – averaging 0.3% – and that automatically leads to higher inflation this year, because we measure inflation on a year-on-year basis.

For example, the Deutsche Bundesbank estimates that the reversal of the German VAT cut last year will add 1.2 percentage points to inflation in Germany in the second half of 2021. But this also means that the same percentage will be subtracted from inflation in Germany in January of next year.

The more important drivers of inflation dynamics today are related to the frictions we are seeing as the economy reopens. These frictions are showing up in two main areas: the surge in energy prices and supply-demand imbalances.

First, energy inflation, which was negative from the start of the pandemic until the spring of 2021, shot up to 23.7% in October. This is by far the fastest growth rate since the monetary union began. It contributed 2.2 percentage points – more than half – to overall inflation of 4.1% in October.

This surge is linked to the reopening of the economy and the recovery in global demand, as well as other special factors. These include restrictions in OPEC+ oil supply, sluggish US shale oil production, and lower gas exports from Norway and Russia. That combination of high demand and supply shortages caused European gas prices to soar to record highs in October this year.

Second, supply-demand imbalances are also visible outside of the energy sector, which is pushing up underlying inflation too. This is being reflected particularly in industrial goods inflation which is currently close to its highest level since 1999 and could increase further towards the end of the year.

The jump in industrial goods prices is a result of, on the demand side, the pandemic-related switch in consumption patterns from services towards goods – for example, people buying home workout equipment rather than renewing their gym memberships – which has still not fully reversed.

On the supply side, manufacturers are facing acute shortages of key inputs, which are then being exacerbated by the “bullwhip effect” – a situation where firms encountering higher demand are placing larger and earlier orders than necessary to ensure goods keep flowing out the door. That ricochets down the supply chain and causes further disruptions and shortages.

Services inflation is also displaying similar – if less pronounced – patterns. People are eating out and traveling again, while labor supply has not yet fully normalized and input costs are rising. In particular, we are seeing high job vacancy rates in some contact-intensive sectors, even as the number of people in employment is lower by around half a million than before the pandemic.

On the back of these factors, inflation is now broadening in the euro area. The share of items in the core inflation basket with inflation rates above 2% has risen to around 45%. This is much lower than in the United States, where that share is labor 75%.”

The near-term outlook

·         ECB is now gradually shifting transitory higher inflation to sticky inflation camp, has no idea when elevated inflation will ease, but remains confident it will ease over time as the underlying economic condition is not supportive for sustainable inflation much above +2.0% target for long

“It is hard to predict exactly when the current drivers of inflation will subside. The pandemic is an unprecedented situation, there are lagged effects at play and we have few past regularities to fall back on. Nevertheless, we remain confident that inflation pressures will ease over time. This is because we do not see the conditions in place – either at the economy-wide level or at the sectoral level – for inflation rates above our target to become self-sustained.

·         As there is considerable slack in the economy/labor market, it will not lead to spiraling wage inflation above productivity levels consistently. There is strong catch-up demand but not excess demand; aggregate demand is still below pre-COVID levels. The Eurozone economy is vulnerable to high energy inflation as it’s a net importer of energy. Higher energy inflation is affecting consumer spending and livelihoods, especially vulnerable sections of society (lower-income people). ECB is confident that due to huge fiscal stimulus and policy action, supply-side lacuna will resolve over time. Although slack in the economy is receding, there are no signs of abnormal wage inflation

“First, for this to happen, an economy-wide “amplification mechanism” is typically required, where output rises persistently above its potential level, with wages and then prices following. But we do not see these dynamics at work in the euro area today.

At present, the euro area is experiencing strong “catch-up” demand, but we do not see excess demand. Aggregate demand is currently below its pre-crisis level. In addition, in the coming months, the rise in energy prices will most likely weigh on consumer spending in the euro area more than it does in other major economies since we are a net importer of energy– although some governments are taking important steps to limit the impact of higher energy prices on the most vulnerable members of society.

At the same time, we have no reason to believe that aggregate supply has fallen significantly, causing the output gap to close from above. In fact, the extraordinarily successful policy response in the euro area was designed precisely to preserve our supply capacity. Slack in the labor market is receding but wage pressures have not yet started to emerge. The growth of negotiated wages remains subdued. This is perhaps not surprising if we remember that, over a longer period, we are not in a high-inflation environment: the average yearly inflation from November 2019 to today is not far from 1%”.

·         ECB believes the present imbalance between supply and demand will be eventually balanced over time and inflation will be down. The present consumption shift from service to consumer durable goods will reverse once COVID is completely over. Normalization of labor and goods/raw materials supply chain coupled with an expected reversal in energy/oil & gas prices in 2022 should help to ease surging inflation. But prices of gas may be elevated even in 2022 as it’s now acting as ‘transition fuel’, which may also keep inflation volatile

“Second, at the sectoral level, the frictions pushing up inflation should be gradually resolved as supply-demand imbalances are ironed out. On the demand side, the large shifts in relative demand, away from services and towards goods, should unwind once the pandemic has passed. Consumption of durable goods surged last year but is now close to its pre-pandemic level. By contrast, consumption of durables in the United States is currently around 30% higher than it was before the pandemic.

On the supply side, the eventual resolution of supply chain disruptions should have a self-limiting effect on inflation. Labour supply should also increase once job retention schemes are phased out and some discouraged workers start looking for employment again.

So far, while frictions exist in some sectors, we do not see broad-based signs of a skills mismatch in the labor market. In fact, employment in the euro area has been recovering strongly, increasing by 0.9% in the third quarter of this year, the second-highest growth rate since 1999.

Finally, although the main driver of higher inflation, the price of energy, is likely to stay elevated over the coming months, it should stabilize in the course of 2022 – as it normally has done historically after a sharp rise. Futures prices for oil, gas, and electricity point to a decline in the coming period, and gas prices have already fallen by about 21% since their record highs in October.

However, prices remain volatile and there is some uncertainty over the longer-run outlook: for example, a global shift away from emission-intensive energy could lead to sustained demand for gas as a transition fuel, resulting in further periods of price volatility.”

The outlook for monetary policy over the medium term:

·         As per ECB’s new strategy, ECB will focus/target on mid-term inflation expectations; i.e. estimates rather than actual data/current inflation as monetary policy acts with a lag. As medium-term inflation expectations are still in line with ECB objective, there is no need for rate hikes/policy tightening despite surging inflation

“So, how should monetary policy respond?

As I have already indicated, in our strategy review we considered carefully how to respond in circumstances where we face pronounced but passing inflation shocks. Three key elements of our strategy are relevant to the current situation.

First, we focus on the medium term, not on current inflation numbers. This is because, for one, monetary policy affects the economy with a lag. So, when inflation pressure is expected to fade – as is the case today – it does not make sense to react by tightening policy. The tightening would not affect the economy until after the shock has already passed”.

·         As there is no excess demand shock apart from strong catch-up demand, ECB believes tightening of monetary policy would be immature, especially when there is no significant wage inflation. As there is supply-side shock and elevated inflation, the economic recovery has turned subdued and in such a situation, tighter monetary policy may result in contraction of the economy

“Second, our strategy tailors our monetary policy response to the type of shock we are facing. If we are facing a demand shock, where domestic wages and prices are being pushed up by excess demand, tightening policy can help cool the economy and bring down inflation. A supply shock, however, will tend to push up inflation and depress output. In this situation, tighter monetary policy would only exacerbate the contractionary effect on the economy.”

·         The current environment of elevated inflation is an issue of lower supply and strong catch-up demand. ECB/Lagarde almost admits a stagflation-like scenario (lower economic growth, higher inflation, and higher unemployment) amid supply chain disruptions and higher energy prices. Thus tighter monetary policy is unwarranted at this stage as it would further squeeze household income. Also, tighter monetary policy will not address will not resolve the root cause of elevated inflation; i.e. supply chain disruptions and higher energy prices

“Today, we are facing a mixture of shocks, which is partly related to catch-up demand but has a strong supply-driven element too. This is clear from the fact that inflation is rising but growth is losing momentum in the near term, as supply disruptions constrain production and higher energy prices eat into demand.

Tightening policy prematurely would only make this squeeze on household incomes worse. At the same time, it would not address the root causes of inflation, because energy prices are set globally and supply bottlenecks cannot be remedied by the ECB’s monetary policy”.

·         ECB will keep rates near to zero (at effective lower bound) in a patient and persistent manner so that stronger inflation dynamics will be self-sustained and thus ECB thinks reacting too early to fight against nascent signs of rising inflation would derail ECB’s effort to reach the inflation target in a durable basis. Thus ECB’s current forward guidance about rate hikes is quite appropriate. ECB’s rate hike conditions are designed to ensure that the central bank does not overreact to supply-driven cost-push inflation shocks in the short/near term and instead focuses on the medium-term. ECB will only go for rate hikes after being confident about strong inflation dynamics on a sustainable basis

“The third key element of the new strategy is our conclusion that, when coming out of a period of too low inflation where interest rates are close to their effective lower bound, monetary policy has to be patient and persistent. This is because it takes time for stronger inflation dynamics to become self-sustained, and reacting too early to signs of rising inflation can derail that process.

We expressed this persistent orientation via our forward guidance on interest rates, where we said that, for rates to rise, we need to see inflation reaching 2% well ahead of the end of our projection horizon and durably for the rest of the projection horizon, and we judge that realized progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilizing at 2% over the medium term.”

These conditions were designed especially to ensure that we do not overreact to supply-driven cost-push shocks that will not persist into the medium term and that, before raising rates, we have a high degree of confidence that underlying inflation dynamics have genuinely improved.”

·         As ECB’s stringent rate hike conditions will be unlikely to meet in 2022, ECB is not even thinking about rate hikes at this moment. Moreover, ECB is thinking about PEPP in some new name/format after the scheduled expiry in Mar’22. ECB will announce the future of PEPP in Dec’21 meeting. ECB is quite confident that due to its patience & persistence, inflation will eventually hit the target so that ECB will be able to hike rates

“As I have recently explained, the conditions to raise rates are very unlikely to be satisfied next year. Moreover, even after the expected end of the pandemic emergency, it will still be important for monetary policy – including the appropriate calibration of asset purchases – to support the recovery and the sustainable return of inflation to our target of 2%. We will announce our intentions in this matter in December. But if we are patient and persistent now, I am confident that these conditions will eventually be met.”

·         ECB expects strong economic recovery by Dec’22; EU GDP should reach pre-COVID levels by Dec’21, while inflation expectations are rising towards ECB target and wage growth should accelerate by 2022

“GDP should reach its pre-pandemic level before the end of this year. Inflation expectations are rising towards our target. Measures of underlying inflation are moving in the right direction. And wage growth, which is a key element of underlying inflation, should start to gradually strengthen. The ECB’s recent contacts with large European companies suggest that wage growth will pick up somewhat next year.”


·         ECB is quite conscious about its price stability mandate, but will not tighten pre-maturely as the current spate of higher inflation is caused by exceptional circumstances as a result of COVID. As ECB believes the current spate of elevated inflation may slow the pace of economic recovery, ECB will be patient with some caution, so that inflation will hit the 2% target in the coming days on a sustainable basis

“Let me conclude.

We do not take this phase of higher inflation lightly. But in our strategy review, we have agreed on how to approach the type of situation we face today. We are committed to ensuring that inflation stabilizes at our 2% target in the medium term. Today, inflation is largely being pushed up by the exceptional circumstances created by the pandemic. And the nature of the inflation is likely to slow the pace of the recovery in the near term.

Monetary policy today must therefore remain patient and persistent while being alert to any possible destabilizing dynamics emerging. This is the best way to ensure that we return to our 2% inflation target on a sustained basis. Now, we need to follow Abraham Lincoln’s maxim and turn this promise into reality. And if we do, we will escape the low inflation environment of the last decade – and monetary policy will be able to adjust.”

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Despite surging inflation, ECB is not in a mood to normalize. ECB’s stringent three conditions for tightening/liftoff (forward guidance) are quite stiff- for rates to rise, ECB needs to see inflation reaching 2% well ahead of the end of the projection horizon and durably for the rest of the projection horizon, and ECB judge that realized progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilizing at 2% over the medium term.

ECB will now explicitly target HICP inflation at 2% (symmetric), sustainable over medium-term (no positive or negative deviations desirable) unlike earlier asymmetric just below 2%. Here inflation means ‘inflation outlook’ or forecast by ECB professional forecaster’s staffs/GC members and not actual real data like Fed is now following. Although the primary mandate of the ECB is price stability, maintaining financial stability is a precondition. ECB will ensure price stability along with inclusive broad-based economic growth/maximum employment, a highly competitive socialistic green economy. ECB will include owner-occupied housing inflation in HICP after some years.

ECB may allow moderately higher/lower inflation from a 2% symmetrical target in case of any exigencies (like COVID) due to probable transitory factors. ECB’s primary policy tool is interest rate; but as it’s already at a lower bound, ECB can’t cut it further, and thus forward guidance, QE and TLTRO are now only tools available.

ECB effectively changed its goalposts (narrative) to stay lower for longer. For 2021-22, the ECB will treat higher HICP inflation around as transitory, will not react, and will judge the same from 2023 onwards to remove those transitory/idiocentric factors.

In 2020, Euro area HICP inflation was +0.06% on a sequential basis (m/m), translating to an annualized rate around +0.75%. In 2021, the HICP inflation is around +0.39% on an average till Oct’21; i.e. an annualized rate of almost +4.66%. In 2019, before COVID, the average HICP inflation was around +0.20% on a sequential basis; i.e. around +2.39% on an annualized basis.

Although ECB always talks about HICP inflation, in reality, for policy setting, it refers to core HICP inflation, not the headline. The average core HICP inflation was around +0.24% sequentially in 2019; i.e. +2.84% on an annualized basis. The 2020 average core HICP inflation was around +0.16% (m/m); i.e. an annualized rate of almost +1.96%. In 2021 (till October), the average core HICP inflation is around +0.27% (m/m); i.e. an annualized rate almost +3.29%.

Unlike the U.S., core inflation and also headline CPI index is abnormally volatile in the Euro Area leading to lower Y/Y reading persistently, although, if measured on an annualized (12-M) basis, the core HICP inflation was around +2.84% in 2019 and +1.96% in 2020 against official average figure +1.3% in Dec’19, +0.70% in 2020, and +1.22% in 2021 (till Oct21). Thus officially, in the last decade, the Euro Area average core inflation never hit the target of ‘just below’ +2%, helping ECB to keep Euro Area interest and bond yield rate always at lower bund or near zero. Such m/m volatility on core/headline HICP/CPI index is quite abnormal; be it statistical jugglery or fragmentation of Euro Area countries, it leads to the deflation-like scenario for the Euro area economy.

In Euro Area, 19 member states (countries) - all are not strong economies like Germany, Belgium, Netherlands or Austria. Even France, Italy and Spain have a quite fragile economy, running structurally high debt compared to the EU Gold standard. Moreover, peripheral economies like Greece, Portugal are quite fragile. Thus, ECB has to ensure lower borrowing costs for these fragile economies in years to come by keeping inflation, interest rates and bond yields artificially/forcefully lower.

The ECB is also open to extending the PEPP beyond Mar’22 until the Governing Council (GC) judges that the coronavirus crisis phase is over and there is substantial progress of ECB’s single mandate of price stability (+2.0% inflation on a durable basis). At the current trend/methodology EZ of core inflation rate (y/y average), the ECB will never be ‘able’ to achieve the ever-elusive target of 2% (y/y) on a sustainable basis (as per stringent rate hike conditions) and thus will be at present lower bound until at least 2025 or forever (even after a so-called transitory period).

ECB is not been ‘satisfied’ with consistent inflation ‘misses’ over a decade and its policy credibility is also now at stake. The ECB was never able to stimulate the economy even by its perpetual ultra-accommodative monetary policy due to lack of adequate fiscal stimulus. Thus ECB miserably ‘failed’ to achieve its inflation target and was never able to hike (normalize) after the 2008 GFC due to the fiscal austerity policy of many EU member states and lack of common fiscal authority.

Now ECB is urging EU member states to take necessary steps for implementation of the common EU Next Generation fiscal/infra stimulus (NGU) immediately, while various EU member states are still divided on the same. This lack of common fiscal authority despite a common currency (EUR) and common monetary authority (ECB) may be the main reason behind EU inequality and fragmentation. The ECB’s current policy of back-door YCC through targeted PEPP (bond-buying) may also accelerate the ‘Japanification’ of the Eurozone economy, making EUR like Japanese Yen- more like funding rather than growth currency. Like Fed, the ECB is also ensuring EU borrowing costs at ultra-low levels to fund common/local fiscal stimulus, and for that ECB may replace PEPP with some other bond program even after Mar’22.

Against such an ‘inflationary backdrop’, the real Euro Area GDP grew by around +2.21% sequentially in Q3CY21 to reach €28.3610B. Looking ahead, the real GDP may grow by around +0.50% in Q4CY21 amid lingering COVID disruptions to reach around €28.5028B. In that scenario, the CY21 real GDP would be around €111.7875B against CY19 (pre-COVID) real GDP of €113.7761B. Even if Q4CY21 real GDP grows by around +2% instead of +0.50%, still the CY21 real GDP will be slightly below CY19 levels.

On the employment front, the Eurozone economy is now still below 1M levels of pre-COVID even after considering the job-retention scheme. In any way, In that scenario, with a normal growth rate of around +0.50% sequential (q/q); i.e. +2%, the Eurozone real GDP may reach the pre-COVID levels of around €11.38T by Q3CY22. The same may be true for the maximum employment front.

Bottom line:

As per ECB’s official stance, as Eurozone inflation is running consistently far below the +2.0% target, ECB never tried to hike rates after the 2008-10 GFC and 2013 debt crisis. Going forward, ECB may also be never able to hike rates (normalization) but may go for QE tapering from Dec’22 or Mar’23 after Fed completes its QE tapering by June 22 and goes for liftoff twice in H2CY22 (as expected).

After the 2008 GFC, ECB was several years behind Fed in QE tapering and this time, it may be the same. The ECB has practically no weapon left except targeted PEPP (backdoor YCC) and ‘powerful’ forward guidance (jawboning) in keeping EU bund yields lower, especially on the peripheral areas; ECB was at almost ZIRP since 2008 GFC and can’t cut lending (repo) rates below zero. The policy divergence between ECB and Fed/BOE is making EUR lower, but as an export-heavy economy, the EU also needs weaker currency, irrespective of ECB and inflation narrative. Looking ahead, ECB may be more comfortable to keep EURUSD around 1.15-1.10/1.05 rather than 1.15-1.20/1.25 zones.

Technical outlook: EURUSD

Technically, whatever may be the narrative, EURUSD now has to sustain over 1.11500; otherwise, expect 1.10-1.07 levels soon; looking ahead 1.15-1.10/1.05 zone for EURUSD should be an equilibrium zone for ECB to promote EU exports and control imported inflation. ECB/Lagarde is doing jawboning acts very efficiently to keep EURUSD within 1.15-1.10/1.05 rather than 1.15-1.20/1.25 levels. Also, the European energy and COVID crisis coupled with Chinese slowdown/deleveraging drive/real estate bubbles are helping ECB is keeping EUR down apart from the huge policy divergence with Fed or even BOE. The current spate of surging inflation is both an issue of supply as-well-as demand. Although any monetary policy tightening does not resolve supply bottlenecks or force OPEC+ to supply more, it will certainly control surging demand as liquidity will shrink and government also tend to provide lower fiscal stimulus amid higher borrowing costs.

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