Markets Geek

This toggle bar can feature specific pinned articles perhaps

How the European Central Bank Disappointed in December 2020


Posted: Tuesday, December 15th, 2020

Estimated Reading Time: 3 minutes

Share this article on

Last Thursday’s European Central Bank decision left Euro bears disappointed. In fact, not even the bulls should be happy, despite the fact that the Euro moved to 2020 highs shortly after.

As usual, the central bank announced its decision in the middle of the London session. The Euro corrected just a bit after the highs in the prior Friday ahead of the NFP report in the United States. In other words, the market was not afraid of the European Central Bank’s decision, continuing to bid for the Euro despite the bank expressing concerns.

 

European Central Bank

Is the European Central Bank Bluffing?

It certainly seems so, if judging only by how the market reacted. In fact, the Euro bounced from every dip the entire week prior to the ECB decision.

The problems for the ECB start and end with its mandate. Every trader knows that the ECB has a target inflationary mandate. More precisely, its view of price stability means bringing inflation below, but close to two percent. Because of that, the more inflation deviates from the target, the more difficult for the ECB becomes to bring it back. Moreover, the longer inflation remains far away from the target, the less credible the central bank becomes.

European Central Bank Interest Rates

Credibility – An Issue for Central Banks

Trust is everything. The inability of a central bank like the ECB to bring inflation to the target spells troubles. One example that comes to mind comes from Asia.

The Bank of Japan struggles for decades to bring inflation to 2%. Because of its constant failures, the market does not believe the bank can fulfill its mandate anymore. As such, it becomes even more difficult because inflation expectations cannot become a self-fulfilling prophecy.

When the EURUSD reached 1.20 for the first time this year, the ECB intervened. It did so verbally by expressing its worries for a high exchange rate and how it weighs on inflation.

Unsurprisingly, the EURUSD and other Euro pairs fell from the highs. They reacted as they should. However, buyers stepped in again. At the same time, inflation continued to fall.

Disinflation gripped Europe, and the threat of deflation is imminent. After all, the core inflation, the one that does not consider energy prices, fell to historic lows.

Fast forward to last week’s decision, and the EURUSD sat at 1.21, EURJPY above 126, and EURGBP above 0.90. The most important Euro currency pairs called the ECB intervention a bluff, and for a good reason.

How to Ease Conditions and Send a Hawkish Message?

The market participants expected a EUR500 billion increase in the PEPP program. This is the bond-buying program the European Central Bank came up with during the pandemic.

The central bank delivered. It did increase the size of the program and expand it until March 2022 – only that the market expected an increase until June 2022. One may argue that it is not important, but in the eyes of the market, this is hawkish, not dovish—every small detail matters.

Moreover, the European Central Bank announced new TLTROs with improved conditions. Indeed, TLTROs or Targeted Long Term Operations are the most efficient way the ECB eases financial conditions. Indeed, it offered improved terms, but the conditions to access the funds became tougher. Therefore, the risk is that commercial banks will not qualify to access the funds, despite the TLTROs having negative rates, among others.

Finally, the European Central Bank reveals its staff projections for the years ahead. In 2023, the core inflation is viewed at 1.2%! Yes, almost three years from now, the ECB staff projections indicate an inflation rate well below its mandate. Judging by the success it had in the past (sense the irony) to bring it to target, we can all calibrate expectations accordingly.

EURUSD Exchange Rate

To sum up, the current core inflation is close to zero. For the core inflation to reach 1.2% in 2023, the EURUSD exchange rate cannot remain so elevated – the more it rises, the more it weighs on inflation.

Hence, one of two things comes next. Either the European Central Bank has something else in its sleeves. Or the market calls its bluff and pushes the Euro exchange rates even higher.

More articles on Monetary Policy