ECB View: Account suggests central bank is relaxed on financial conditions but with caveats – The account of the January Governing Council meeting provided some interesting insights with regards to the ECB’s approach to financial conditions, which is a key factor for monetary policy going forward. The account of the discussion helps to us to provide additional colour on a number of key questions.
What is the ECB aiming for in terms of financial conditions? The account emphasises that ‘ample monetary stimulus remained essential to preserve favourable financing conditions over the pandemic period for all sectors of the economy’. This reflected ‘that the projected path of inflation in the December Eurosystem staff macroeconomic projections continued to be distant from the Governing Council’s medium-term inflation aim’.
How does the ECB define financial conditions? In the account the ECB refers to a range of financial conditions indexes that it looks at, which tend to aggregate a number of variables that the ECB mentions specifically: Sovereign real yields, spreads, stock prices and the euro exchange rate. Over and above this, the ECB seems to pay attention to a number of specific individual elements. Sovereign yields are monitored looking at the ‘euro area GDP-weighted yield curve’. In addition, the ECB monitors bank lending to the private sector and the results of the bank lending survey. So its assessment is rather broad.
What was the ECB’s assessment of financial conditions in January? The ECB was satisfied with developments in financial conditions. It noted that ‘recent financial market developments had left a broad-based positive mark on financial conditions in the euro area. Sovereign real yields had dropped, spreads had remained resilient, stock prices and inflation expectations had risen, and the euro exchange rate versus the US dollar had reversed its appreciation trend’. It added that ‘the euro area GDP-weighted yield curve had also remained very close to the level observed at the time of the Governing Council’s 9-10 December 2020 monetary policy meeting’ while ‘real yields in the euro area had resisted upward pressure and had in fact declined to record low levels’.
Despite the overall assessment, there were some caveats. First, the ECB noted the ‘continued net tightening of credit standards that had been reported in the January BLS’. As such ‘the results of the BLS warranted careful monitoring as they could signal a further tightening ahead with corresponding negative consequences for credit flows and economic activity’. Second, ‘monthly lending flows had moderated since the end of the summer, which could translate into weak investment dynamics over time. However, it was also argued that firms had built up sizeable precautionary buffers and the recent slowdown in credit should not be interpreted as the start of a financial amplification cycle.’ Third, ‘developments in the euro exchange rate should continue to be monitored with regard to their possible implications for the medium-term inflation outlook.’ Finally, the risk was noted that ‘stock prices could eventually become vulnerable to a rise in real yields globally’.
Has the situation changed since the meeting? In broad terms, the ECB’s assessment of financial conditions is unlikely to have changed in our view. Although yields have risen, the rise in the euro area GDP-weighted yields has unlikely been significant enough to set alarm bells ringing. In addition, Financial Conditions Indexes have not moved much and still point to easy financial conditions. We will discuss the more recent developments and what could trigger a change in assessment by the ECB in more detail in an upcoming note.