U.S. Markets

Dark days are far from over: Five questions for the ECB

LONDON (Reuters) - The European Central Bank will this week face more questions about an increasingly challenging outlook only a month after it unleashed fresh stimulus to bolster the euro zone economy.

FILE PHOTO: The headquarters of European Central Bank (ECB) is photographed n Frankfurt, Germany, January 14, 2021. REUTERS/Kai Pfaffenbach/File Photo

Policymakers boosted emergency bond buys by 500 billion euros ($607 bln) in December. But resurgent COVID-19 cases, new restrictions on activity in countries including Germany and France and the slow roll-out of vaccines has cast doubt over the pace of the region’s recovery.

“At this point in time, the ECB still finds itself a little bit with its back against the wall,” said Althea Spinozzi, fixed income strategist at Saxo Bank Group. “There’s no alternative but to keep supporting the economy until an end to downside risks are clear.”

Here are five key questions for markets.

1. What does a slow vaccine roll-out and surging COVID-19 cases mean for the economy?

ECB chief Christine Lagarde is sticking to forecasts for an economic rebound this year so long as lockdown measures to curb the pandemic are lifted by end-March and vaccines distributed.

She said in a Reuters interview last week that the latest ECB forecasts incorporate some impact from restrictions. The next forecasts are due in March. Real GDP should return to pre-crisis levels by mid-2022, minutes from the ECB’s December meeting show.

Still, lockdown extensions have dashed hopes of an early rebound and economists are cutting their forecasts. Bank of America now estimates a 2021 growth expansion of 2.9%, a full percentage point below previous expectations.

Markets will therefore closely scrutinise the ECB’s assessment of the balance of risks and will want a sense of whether more stimulus is likely this year.

(Graphic: Renewed surge in COVID-19 cases in Europe - )

2. How committed is the ECB to using the full PEPP envelope?

Policymakers debated a smaller increase in emergency bond purchases last month and were keen to emphasize that they may not spend the full quota.

And in December, the ECB chief did not commit to using the full weight of the 1.85 trillion euro Pandemic Emergency Purchase Programme (PEPP)..

An uncertain outlook, however, could lead to some unease in markets.

“What will make markets nervous in the coming quarters is how much of a commitment there is to see the package through,” said ING senior bond strategist Antoine Bouvet. “The hawks will insist it’s not needed, I suspect they will have to do more than less.”

(Graphic: The ECB's pandemic stimulus programme - )

3. Surely the ECB will welcome positive signs for inflation?

A key gauge of long-term euro zone inflation expectations, tracked closely by the ECB, is near 18-month highs.

The rise follows the expiry of a temporary cut in German value added tax, which had depressed prices, and a 50% jump in crude oil prices since November.

While welcome signs for inflation, a weak economy will continue to weigh on prices. Analysts note that the U.S. reflation trade can also explain rising euro zone inflation expectations.

The ECB’s Isabel Schnabel believes a short-term inflation rise will not have a material impact on monetary policy decisions.

(Graphic: Euro zone inflation expectations pick up - )

4. What about the euro?

The euro has weakened in recent days, but is not far off its highest levels since early 2018.

Analysts polled by Reuters forecast a gain to $1.25 by end-2021, a 3% rise from current levels.

Lagarde has said that the ECB would be “extremely attentive” to the impact of a strong currency on prices. She may be asked again about the central bank’s pain threshold for currency strength.

(Graphic: Euro during the coronavirus crisis - )

5. Could the ECB consider yield curve control?

The ECB’s Pablo Hernandez de Cos said this month that the ECB should consider moving to yield curve control to raise inflation.

Australia and Japan already target parts of the sovereign bond curve to pin down borrowing costs. But the policy is more complicated for the ECB since it does not have a single government bond market.

While economists expect the option to remain in the ECB toolkit, they do not think it will be adopted soon.

(Graphic: Next up in yield curve control: ECB? - )

Reporting by Dhara Ranasinghe, Graphics by Ritvik Cravalho; Editing by Tommy Wilkes and Toby Chopra