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The European Central Bank is reducing its stimulus for the economy, but CEO Christine Lagarde emphasizes that it will only be decided in December whether the money tap will be turned off even more. She does not want to talk about tapering, a continuous reduction in bond purchases. Nevertheless, this is a first step towards a normalization of monetary policy.
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The European economy will receive less support from the ECB in the coming months, as inflation prospects have risen and economic activity grows faster than expected.
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What has the ECB decided?
The ECB announces a ‘moderately slower pace’ of bond purchases. Since April, it has been buying around 80 billion euros of debt securities per month with its pandemic program (PEPP). These purchases were supposed to keep long-term interest rates low and provide the economy with sufficient oxygen. “We expect the ECB to buy bonds worth EUR 60 to 70 billion per month until the end of this year,” said Carsten Brzeski, ING’s head of macroeconomics.
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The ECB has injected 1,342 billion euros into the economy through the PEPP program over the past year and a half. That amount is an important part of the much larger overall stimulus since the start of the pandemic. Since March last year, the ECB has bought bonds worth more than 1,700 billion euros through two purchase programs and increased ultra-cheap loans to banks by about 1,600 billion.
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As a result, its balance sheet total rose to approximately EUR 8,200 billion (see chart). The decision to buy less bonds will cause the balance sheet to grow somewhat more slowly in the coming months.
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Why is the ECB reducing its bond purchases?
The communication refers to the favorable financing conditions and the inflation outlook. Long-term interest rates have fallen in recent months. Companies, households and governments can therefore continue to borrow money at very low interest rates. The ECB is convinced that interest rates will remain low even with less bond purchases.
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In addition, the ECB has raised its inflation forecasts. She now expects 2.2 percent inflation in 2021, 1.7 percent in 2022 and 1.5 percent in 2023. “The rise in inflation is largely temporary,” ECB president Christine Lagarde said at a press conference. “Inflation in the medium term remains below our target of 2 percent.”
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But Lagarde hinted that the ECB is a little more wary of inflation risks. ‘If the supply-side bottlenecks last longer and trickle down into higher-than-expected wage increases, the price pressure could be more persistent.’ Brzeski believes the ECB is ‘finally’ assessing inflation in a ‘realistic way’. “That’s a very important change.”
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Lagarde also referred to the economic recovery. “Economic growth was higher than expected in the second quarter and economic activity will surpass pre-corona levels by the end of this year.” The ECB raised its growth forecast for 2021 to 5 percent and expects 4.6 percent growth in 2022 and 2.1 percent in 2023.
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When will the stimulus be further reduced?
“The lady is not tapering,” said Lagarde. In doing so, she emphasized that the decision should not be regarded as the start of a continuous reduction in bond purchases.
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Lagarde underlined that the ECB will not make a decision on the future of the pandemic program until December 16. This will run until at least the end of March 2022, but can be extended. Robert Holzmann and Klaas Knot, the Austrian and Dutch ECB executives, want to end the program at the end of March.
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While the ECB is keeping all options open for next year, observers believe the cut in bond purchases is the start of a gradual easing of the stimulus. But that reduction will be slow, and therefore take a long time. Even if the ECB pulls out of the pandemic program in March, that won’t be the end of bond buying. The ECB buys debt securities worth EUR 20 billion each month through another program (APP). These purchases will continue for some time to come.
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It looks like the era of low interest rates will continue for years to come, as inflation will remain below target after this year’s surge at least until the end of 2023. Analysts do not expect the first rate hike until 2024.
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How do the markets react?
Long-term interest rates fell after the ECB announced a cut in its bond purchases. Interest rates should normally rise somewhat, but bond markets had already anticipated the decision and the ECB made it clear that the stimulus remains significant. German and Belgian 10-year yields fell by 3 basis points to -0.36 and -0.05 percent respectively. Italian interest rates fell by 7 basis points to 0.67 percent.
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Not only the bond markets, but also the equity markets reacted positively. The EuroStoxx50 was able to make up for the morning’s losses and closed unchanged. The Bel20 partially recovered and ended 0.3 percent lower. The euro crumbled slightly.
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What are the consequences for savers and borrowers?
Little or nothing may change in the near future. The fall in long-term interest rates neutralizes part of the interest rate rise of recent weeks. Economists expect long-term interest rates to rise later this year and next year. This would also increase the interest on mortgage loans. The interest on savings accounts, which is mainly determined by the market interest rate in the short and medium term, will remain historically low for years to come.
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