The latest position of the ECB

Christine Lagarde, President of the ECB, gave a press conference on 10 June following a meeting of the ECB’s governing council. Her speech contained some unequivocally positive observations about the European economy, lamenting a bounce back in services activity, continued strong manufacturing activity and improving consumer spending, all against a backdrop of strong global demand. To quantify the ECB’s observations, she told us that the central bank’s economic growth expectations for 2021 and 2022 will be raised to 4.6% and 4.7% respectively.

At the same time, Lagarde spoke of the need to reduce uncertainty and support confidence for firms and households and said that reducing the ECB’s accommodative monetary policy would risk derailing the ongoing recovery. Therefore, the ECB is committed to maintaining its pandemic emergency purchase programme (PEPP) which by its earliest termination date in March 2022 will have deployed €1.85bn to purchase government bonds. Furthermore, she announced that the ECB will be purchasing bonds at a significantly higher pace in Q3 of this year, compared to the rate at which it was doing in first months of this year.

One may notice the apparent contradiction in loose monetary policy concurrent with strong economic recovery. This comes down to controlling the cost of borrowing in the Euro Zone at both a government and corporate level. When a central bank withdraws stimulus by reducing its asset purchases it sends prices lower and yields higher for the instruments that it would buy, in this case European sovereign bonds. Higher yields equate to increased borrowing costs for the countries that issue those bonds as well as the companies within those countries, whose corporate bond yields are a function of their government’s bond yields. A higher cost of borrowing at a national and corporate level has the effect of reducing investment and consumption within an economy, which is ultimately what markets had started to anticipate in May and what the ECB wishes to avoid. Christine Lagarde has sent a message that any rise in borrowing costs will not be allowed to get out of hand.

Traditionally this combination of loose monetary policy and economic growth leads to overheating in the economy and creates inflationary pressure, which can force the hand of central banks to tighten conditions and thereby curtail economic growth. For investors this can mean abruptly falling bond prices and equity prices being shaken by the impact of increased borrowing costs on corporate profitability. In the case of Europe, the problem it has faced with inflation over the last decade is one of not enough, rather than too much, and we shouldn’t conflate the debate around blowout US inflation fuelled by unprecedented fiscal stimulus with what is happening in Europe. In her speech Lagarde said that while supply bottlenecks and energy prices may cause a temporary spike in inflation, core inflation will settle to 1.4% in 2023, below the stated target level of the ECB of 2%.

So, what should investors make of all these moving parts? An ECB unconstrained by inflation concerns and keen to keep monetary policy loose while the economy recovers post-Covid. The answer is that, for now, investment conditions are broadly benign – the economy is on the path to recovery, the ECB has demonstrated that it will remain accommodative, and even though the PEPP may no longer be justifiable two years after the outbreak of Covid in Europe we should not forget that there are other asset purchase programmes which can be reinstated to keep a lid on borrowing costs, should they become a threat to the economic recovery. Further out however, the prognosis is less clear and once the fog of Covid lifts Europe will be faced with its perennial issues including double digit unemployment in some peripheral countries, large government deficits, worsening demographics and an economy with a large banking sector struggling under the weight of negative interest rates.

-Written by James Hunter-Jones, CFA