The board of the European Central Bank (ECB) decided yesterday (Thursday) to keep key interest rates unchanged. With the main interest rate, the refi rate, still at 0%. What does bank president Christine Lagarde say about this?
Investors, economists and analysts were looking forward to her statement, also given the recent rise in the value of the euro. It has increased in value by more than 10% against the US dollar since June, which is quite a movement on the currency market. Besides being a decent one, it is also an important movement.
If the euro becomes more expensive, this will reduce economic growth and inflation. Growth is being pushed down because things made in the eurozone become more expensive abroad, expressed in dollars. The eurozone exports quite a lot. Inflation is coming under downward pressure because products that the eurozone imports - such as oil - become cheaper in euros. That is a problem for the ECB, because the bank has been working hard for a long time to boost both growth and inflation.
Action on value increase
However, it became clear in the first seconds of the press conference afterwards that the bank does not intend to do anything about the increase in the value of the euro (for example by hinting at an even looser monetary policy, which makes the currency less attractive). Lagarde said there are signs of a strong rebound in economic activity since July. And that is not exactly preparatory work for announcing a broader policy.
On the other hand, momentum in the services sector, by far the largest part of the economy, has weakened somewhat recently. And the uncertainty about the further course of economic recovery remains high. In other words: it was a story of 'there is no freezing and no thawing'. But there was another reason why the ECB made no effort to use specific words to talk the euro down.
Change in value of euro
It is true that changes in the value of the euro affect inflation. However, this effect is small under normal economic circumstances and also occurs with a considerable delay. If the value of the euro changes, it usually takes a year for the effect to become visible in inflation. That effect, according to research by the ECB itself, is approximately 0,1 percentage point lower inflation for every 1% increase in the value of the euro after one year. But that increase in value must be long-term, i.e. last longer than about 3 months. Whether the recent increase in the value of the euro will meet this requirement is completely unknown. Also for the ECB.
Moreover, research shows that the effect of the change in the value of the euro on inflation becomes weaker over time. It is therefore very possible that the ultimate effect on prices in the euro zone will turn out to be weaker than what you would expect based on the past.
Deep recession, strong recovery
In 2020, the economy has entered a deep recession due to the coronavirus, which almost by definition means that the recovery will be relatively strong. Compare it to bouncing a ball that you throw down from 15 high: it will bounce back quite high.
The ECB expects that the eurozone economy will grow by 8% after an 5% contraction this year. Economic growth usually also increases inflation. As a result, it is entirely possible that the upward pressure on prices from that quarter will neutralize and exceed the downward pressure from the recent appreciation of the euro.
That is what the ECB also assumes, according to the bank's expectation that inflation will rise in the medium term. The bank sees monetary depreciation at 0,3% this year, 2021% in 1 and 2022% in 1,3. Please note that when making these estimates, the current level in euro/dollar was already assumed. So it is not as if that effect still needs to appear in the estimates.
Keep buying bonds
Given all the uncertainties and estimates for growth and inflation in the coming years, it is logical to expect that the bank will keep interest rates at 0% all this time and continue to buy government and corporate bonds.
The ECB aims for annual inflation of below, but close to, 2%. The 1% expected inflation next year and 1,3% in 2022 is clearly below, but not close to, 2 percent. In other words: the bank must continue to provide adequate incentives to boost prices sufficiently in the coming years. In fact, I think it is likely that they will come to the conclusion this year that more stimulation is needed. It is then obvious to increase the bond purchase program by several hundreds of billions.
Buying up debt securities
This stimulation means that the bank not only keeps the interest rate at 0% for years to come, but at least until the end of this year it buys debt securities from the euro countries for almost 60.000 euros per second.
Finally: there is one piece of news to report after listening to Lagarde's press conference. Lagarde, not originally a monetary economist, is slowly becoming at least a real central banker in terms of communication. She showed that she is increasingly mastering the art of using many words, but not answering the question. Or even not answer the question at all.