Global Daily – Below target inflation outlook continues to drive ECB policy making

by: Nick Kounis , Aline Schuiling , Bill Diviney , Arjen van Dijkhuizen

ECB View: ECB will continue higher purchase pace in Q3, despite upgrades – The ECB upgraded its economic outlook and the balance of risks, but decided to sustain the higher PEPP purchases and signalled the need for ongoing easy financing conditions. This reflected that the medium term inflation outlook remained relatively weak. Below we explain the ECB’s decision and projections in more detail and finally set out our views on the outlook for policy.

PEPP step up will be sustained – The Governing Council’s press statement contained largely the same forward guidance as in the previous one. The one addition is that the ECB intends to sustain net purchases under the PEPP at the ‘significantly’ higher level in Q3 following the step up in Q2 (compared to levels seen earlier in the year). This points to net purchases under the PEPP of around EUR 80bn per month, and EUR 100bn taking into account the amounts under the APP as well.

The decision was ‘based on a joint assessment of financing conditions and the inflation outlook’. While the rise in long-term interest rates partly reflected ‘improved economic prospects, a sustained rise in market rates could translate into a tightening of wider financing conditions that are relevant for the entire economy. Such a tightening would be premature and would pose a risk to the ongoing economic recovery and the outlook for inflation’. This is seen as been unwarranted given subdued underlying inflationary pressures and the ECB expecting inflation to be below its target over the medium term, despite upward revisions.

Higher macro projections, balanced risks –  Indeed, the ECB’s macro staff projections showed upward revisions for both economic growth and inflation this year and next, though the 2023 outcomes were stable. The changes are shown in the charts below. The upward revisions to economic growth are mainly centred on the second half of the year, with the higher annual average in 2022 due to base effects. The stronger growth profile, especially in Q3, is due to the anticipation of a faster easing of containment measures, additional fiscal support and the view that there would be more pent-up demand released than earlier expected. The upgrades to inflation reflected higher commodity and food prices, but also the effects of stronger economic growth, which would mean slack would be absorbed more quickly. Indeed core inflation (not shown in the charts) was revised up slightly (by 0.1 percentage point in each year), while still leaving it at just 1.4% in 2023. Ms. Lagarde made a point of asserting that underlying inflationary pressures would – while rising – remain subdued overall.

Meanwhile, the ECB also upgraded its assessment of the risks surrounding the euro area growth outlook to ‘broadly balanced’, while they were previously seen as being skewed to the downside. The ECB explains that on the one hand, an even stronger recovery could be predicated on brighter prospects for global demand and a faster-than-anticipated reduction in household savings once social and travel restrictions have been lifted. On the other hand, the ongoing pandemic, including the spread of virus mutations, and its implications for economic and financial conditions continue to be sources of downside risk’.

Outlook for ECB policy – The September Governing Council meeting will be a significant one for the ECB. The central bank will likely announce the outcome of its Strategy Review. One of the key elements of that review will be a more ambitious inflation target (symmetry around 2%). Therefore, the gap between its projection of inflation and its inflation goal will be larger. At the same time, it is likely to give a stronger signal that the PEPP will indeed likely end in March 2022 and will therefore have a challenge to manage market expectations that an end to the PEPP will not lead to early rate hikes. The ECB could push back against these expectations by strengthening its forward guidance. This can be done by signalling much more explicitly that policy rates will remain on hold for a much longer period than markets expect. Alternatively, it could send the same message indirectly by signalling a much longer period of net purchases under the APP beyond (and perhaps with more flexibility and volume than currently) when the PEPP ends in March 2022. (Nick Kounis & Aline Schuiling)

US Macro: Another US inflation upside surprise, but scope for payback – CPI inflation again surprised to the upside, with the core measure jumping another 0.7% mom – decelerating from April’s 0.9% rise, but still well above what we would see in a normal month in the US (0.2%). Similar to April, around 1/3 of the rise was driven by used cars – linked to current exceptionally strong demand (fuelled by stimulus checks) and temporary car production difficulties that are weighing on supply. We do not view these sorts of price rises as sustainable, and see scope for this category becoming a drag on inflation in the coming months. While services inflation has also firmed, this is driven entirely by narrow categories benefiting from the reopening, such as airfares. Other services categories – for example shelter and medical costs – are growing at a more benign pace. In big picture terms, inflation will likely remain volatile over the coming months as the newly reopened economy finds a new equilibrium. However, provided that inflation expectations remain well anchored (our base case), we expect monthly inflation readings to stabilise at more normal levels later in the year. (Bill Diviney)

China Macro: Gradual, targeted lending slowdown continues – China’s May data on lending and monetary aggregates published on Thursday morning point to stabilisation compared to last month. Money supply growth (M1 and M2) more or less stabilised in May, after a clear deceleration in the first months of this year. Lending aggregates (total financing and new bank loans) grew by similar amounts as in April, and – on balance – came in quite close to consensus expectations. In annual growth terms, aggregate financing continued its gradual slide, dropping to a 15-month low of 12.2% yoy (April: 12.3%). Looking beneath the surface of the headline numbers, the crackdown on shadow banking continues, with the negative contribution of shadow banking components to total financing picking up again over the past few months – see chart. All in all, the slowdown of credit growth continues to behave in a gradual manner, and suggests that the government is on its way to reach the goal of capping the pace of credit growth to that of nominal GDP growth this year. All this fits to Beijing’s stronger focus on financial de-risking, with the credit cycle having turned now that China’s economy has largely recovered from the pandemic shock. (Arjen van Dijkhuizen)