Stimulus, policy divergence and inflation

With an ever-evolving economic environment, major central banks take on the rigorous task of reviewing their strategy and adjusting the policy framework periodically. For the Fed and the Bank of Canada (BoC), for example, this review typically takes place every 5 years. The European Central Bank (ECB) last completed its review in 2003, and almost two decades later, it recently released the results of an 18-month monetary policy strategy review. The outcome of it? Not as impactful as one would expect.

In an effort to provide further clarity, the ECB revised its inflation target to be more in line with global benchmarking at a flat 2% level. Unlike the Fed’s 2% averaging target, which allows for inflation overshoots (look at the last two US inflation prints at 5% and over), the ECB does not seem accommodating of deviations outside its objective, at least not longer-term. With the strategy review now complete and a new target inflation level established, it will be interesting to see how the ECB adjusts its forward guidance at the upcoming policy meeting.

Following the shift in rhetoric from the Fed last month, major central banks around the world have been active in discussions or acting on taper strategies as seen by the BoC, Reserve Bank of New Zealand, Reserve Bank of Australia, and Norges Bank. The ECB however was quick to dismiss any accordance to this path and went to great lengths to highlight the differences between the regions.

With that said, and the ECB now revising its inflation target, there is further latitude for the central bank to ramp up its pandemic related asset purchases to stimulate activity in a region that has struggled with low inflation levels over the years. This could potentially result in continued accommodative policy measures beyond the set expiry of the Pandemic Emergency Purchase Program (PEPP) in the spring of 2022. In that event, policy divergence with the other central banks will continue to drift apart and lead to further declines in the Euro.

There has been a decent sell off in EUR in recent weeks, and we have seen net long positioning pare back (see Chart 1). The market looks towards the upcoming ECB meeting on July 22 and will assess the impact of its new policy strategy and how it weighs on forward guidance. In order to support the new inflation mandate, I would expect a dovish tone from the ECB along with a commitment to holding / extending its policy. It is fair to say that further monetary stimulus may also be required to support the higher inflation target, and the market will look for an indication from the ECB on the size of its asset purchases going forward.