But the economic revival doesn’t mean the ECB will cease its asset purchases altogether. With inflation still far from target, a rate hike is still several years away, so the ECB is likely to be buying bonds via the APP for some time to come.
Recalibrating the APP Purchasing Pace
Predicting how the ECB will set the APP purchase volume once the PEPP has expired is more difficult.
One possibility is to use September 2019 as a benchmark. When the ECB restarted the APP in 2019, the economy was slowing, risks were tilted to the downside and the central bank had lowered its 2021 core inflation forecast to 1.5% from 1.8% at the beginning of the year. Today, the economy is accelerating, risks are seen as broadly balanced and the ECB has raised its 2023 core inflation forecast to 1.5% (from 1.2% at the beginning of the year). Inflation expectations are also well above September 2019 levels: at 1.75%, the five-year/five-year forward inflation swap is roughly 50 b.p. higher.
Based on these numbers, it’s hard to make the case for a higher APP pace than in September 2019. But a lot has changed in two years. Not only has the ECB raised its inflation target to 2.0% and formalized the target’s symmetrical nature, but it has also stressed the need for monetary policy to be more “persistent” when interest rates are near the effective lower bound. The Governing Council has also shifted the PEPP’s focus away from the volume of purchases and toward preserving favorable financing conditions.
The Era of Fiscal Dominance Has Arrived
A final consideration in the policy path is the size of fiscal deficits. In 2019, the euro area was running a budget deficit equal to 0.6% of GDP, and the ECB expected a deficit of 0.8% (just short of €100bn) in 2020; last week, the ECB forecast a 3.0% deficit (about €390bn) for 2023. As ECB Chief Economist Philip Lane recently noted: “you cannot think about the volume of the APP independently of the volume of net bond supply”—a statement that runs perilously close to an admission that fiscal dominance has arrived.
Implications for Financial Markets
So where does this leave us?
Comparing economic conditions today with those in September 2019 would point to a significant reduction in the pace of ECB asset purchases next year (back to €20 billion a month). But the continued inflation shortfall relative to target, the need for persistence and the risk of spooking the bond market all call for a more gradual adjustment (to, say, €40–50 billion a month).
There are other reasons for caution. Not only does the potential for spread widening in noncore euro-area countries put the ECB in a unique position among central banks, but it’s also worth noting that inflation expectations fell away quickly the last time the Governing Council sought to wind down its asset purchases (Display left, below).