Morgan Stanley
  • Thoughts on the Market
  • Jan 12, 2021

High Noon at the ECB Corral

With Reza Moghadam


Welcome to Thoughts on the Market. I am Reza Moghadam, Morgan Stanley's Chief Economic Advisor. Along with my colleagues, we bring you a variety of market perspectives. Today, I'll be talking about what to expect from the European Central Bank in 2021. It's Tuesday, January 12th, at 2pm in London.

European policy makers, often paralyzed by divisions, finished 2020 on a high note. They finalized the €750 billion European recovery fund, agreed to ambitious climate targets and, via the European Central Bank, announced new measures to ensure easy financing conditions in the coming year. Together with a reliable vaccine pipeline, all this makes for a strong outlook for 2021.

So does a robust recovery spell the end of ECB action?

Only one inconvenient fact stands in the way: the ECB's chronic inability to deliver on its inflation target of close to, but under 2%. Unlike in the U.S., inflation in the euro area has been closer to 1% than to 2% for most of the last eight years, and markets are currently expecting that to remain the case for the next decade.

A sinking inflation anchor is a grave problem for any central bank. Lower bond yields don't help if expected inflation falls at the same time, leaving expected real rates unchanged. The ECB could soon find its effectiveness compromised and bracketed, by the markets, with the Bank of Japan as an institution perpetually at war with the risk of deflation.

The complication for the ECB is that an influential hawkish minority at the ECB Governing Council is prepared to shrug off their low inflation problem, declare victory and bring stimulus to an early end.

The problem with accepting lower inflation, aside from raising real debt burdens, is that it doesn't leave much room for price and wage adjustment between different euro area countries with starkly different needs and vulnerabilities. And with the Fed moving in the opposite direction, it risks casting the ECB as a congenitally hawkish central bank. This could strengthen the Euro and push down inflation even more.

My sense is that the doves, not the hawks, at the ECB will ultimately prevail, especially given the risk of long term economic scarring from the pandemic. The compromise between the doves and the hawks might be to simply eliminate the ambiguous "close-to-but-under" clause attached to the current target. It is less likely that the ECB would follow the Fed's lead in adopting an average inflation target which, by stoking expectations of above 2% inflation in coming years, has the advantage of better countering current inflation pessimism.

What about the toolbox needed to achieve its inflation target. Here, rather than tweaks to its well-worn asset purchase and bank credit programs, the ECB should look to something bolder. The most potent instrument may be coordination with fiscal policy. The taboo against coordination made sense in a high growth world where perceived collusion risked high inflation. But in a world of secular stagnation, sustained public investment will be key to lifting aggregate demand and inflation. The ECB must be clear it will pull in the same direction as fiscal policy, even after the pandemic. In fact, Europe's emphasis on green spending may provide an opportunity to do so.

These two critical issues, the inflation target and policy instruments, are to be taken up in the ECB's upcoming strategy review. Despite its jargonistic ring, the strategy review, expected to be completed in mid-2021, will be the ECB's most consequential policy pronouncement this year.

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Does a robust recovery in 2021 spell the end of European Central Bank action? One inconvenient fact may stand in the way: the lackluster rise in inflation.

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