Weekly Update - Towards a monetary policy normalisation

Fed more hawkish than consensus; ECB follows script
The week was dominated by the decisions of central bank monetary policy committees. In the United States, the Federal Reserve accelerated its tapering of asset purchases, from USD 15 billion per month to USD 30 billion per month, which will mean zero net purchases by March. It also upgraded its 2022 growth forecasts from 3.8% to 4%, its outlook for underlying inflation from 2.3% to 2.7% and now expects to hike short-term rates three times to plateau at 2% for the medium term.

In Europe, as widely expected, the ECB said it would be phasing out net purchases under its Pandemic
Emergency Purchase Programme (PEPP) by March 2022. To accompany the wind-down of  his programme, it announced that (i) it would continue reinvesting maturing PEPP assets until 2024 and, crucially, (ii) expand its old pre-COVID asset purchase programme (APP) by EUR 40 billion per month in Q2 2022 and a further EUR 30 billion in Q3 2022 to prevent a cliff-edge in April. Finally, the Bank of England surprised markets at its latest meeting by raising the policy rate from 0.10% to 0.25%.

ECB still has the luxury to be more patient
At the Fed’s press conference, Jerome Powell justified accelerating monetary tightening by claiming its medium-term targets of full employment and inflation around 2% are likely to be met in 2022. Despite a labour participation rate still below pre-crisis levels, Powell claimed the economy is near maximum employment as many people have retired early while the recovery of the employment for the “prime age” population (25-54) has been robust so far. On inflation, Powell cited the risk that persistently high inflation would destabilise inflationary expectations. Christine Lagarde, meanwhile, stressed the gradualist approach to monetary policy normalisation. Energy remains the biggest upside contributor to the ECB's inflation projections. Lagarde also noted they were not seeing any wage pressures so far. Finally, the APP has not only been expanded but also extended indefinitely. 

Financial markets query transitory nature of inflation
Equity markets in Europe and the US welcomed these announcements. The Fed may have struck a more hawkish tone but its outlook still sees a target rate below neutral. Bond markets, in contrast, continue to expect modest inflation and limited monetary tightening, with 10-year yields staying around 1.5% and further flattening of the yield curve. In the euro zone, the reaction by debt markets was mixed, with Italian and Greek sovereign yields edging up. Remember that unlike the PEPP, the APP is restricted to investment grade assets, which rules out Greek sovereign debt.

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