The US bond sell-off that followed the passage of President Joe Biden’s $1.9tn stimulus plan earlier this month sent waves through global bond markets. The infamous bond vigilantes asked what was to become of central banks’ accommodative stance after such a boost to incomes. It had suddenly become clear that policies would lead to very rapid growth. And this is starting to revive inflation expectations.
In Europe, the economy still needs to get back on its feet. Income support has been less generous, and ambitious public investment plans will not start to unfold until the second half of the year. It will take a few quarters for any inflation that merits attention to make waves. Still, the bond market has spoken and the question has been asked: once the economy reopens and recovery takes hold, how will central banks manage their toolbox to exit extraordinary accommodation?
Not unlike other central banks, the European Central Bank faces a difficult trilemma. First, it must remain focused on its mandate to keep inflation low. If inflation starts to accelerate, it will have to raise interest rates to anchor expectations.
Second, it needs to tighten policy without roiling markets about the end of cheap money. There may be some complacency in the system about proper risk pricing when financing costs have been kept so low for so long. Spreads are compressed and equity valuations have relied on a low discount rate. The ECB will have to manage an orderly exit, at the risk of planting the seeds of a proper recession if market rates overshoot and equity markets tumble.
Third, the central bank cannot subject the timing of its move to concerns about the sustainability of large public debts in the euro area. Normalising interest rates, ensuring financial market stability and preserving the independence of its policy feels like an impossible trinity.
Some see the adoption of yield curve control as the only solution to address the challenge. A credible central bank that targets the 10-year yield at a desirably low level can raise its short-term policy rate without fearing that markets pass it through along the yield curve. Such an explicit announcement also saves on bond purchases to implement the strategy. It anchors inflation expectations while avoiding an excessive tightening of financing conditions. It also contains the threat to public finances.
It is a pity that this policy appears impossible in the euro area, with its 19 sovereign yield curves – some more susceptible than others to price-in sovereign risk when funding costs start to rise. Partly due to this, concerned markets did not feel the ECB could manage a return to normal conditions: the mid-March US bond sell-off caused European yield curves to steepen rapidly.
Unbeknown to all, however, the ECB has laid the ground for a much better strategy. In a press conference in January, President Christine Lagarde stated that the ECB will not be ‘riveted to any particular yield’, but focus on all points and all curves for a holistic policy. Bank lending rates, corporate yields and sovereign bond yields are all part of this multifaceted approach that few have been able to decipher so far.
The ECB will use forward guidance to steer policy rate expectations, inject vast amounts of free central bank reserves to keep banks and corporates liquid and purchase assets along the curve to avoid any meaningful rise in long-term funding costs. In its quest for serenity, the ECB must however consider revising the announced sequencing of its moves and phase out asset purchases only after policy rates are increased. Markets may freak out, but the ECB can stay calm.
Agnès Belaisch is Chief European Strategist, and Matteo Cominetta is Director of Economic Research, Barings.