Account of the monetary policy meeting of the Governing Council of the European Central Bank (15-16 December 2021) (502 KB)

20 January 2022

Meeting of 15-16 December 2021

Account of the monetary policy meeting of the Governing Council of the European Central Bank held in Frankfurt am Main on Wednesday and Thursday, 15-16 December 2021

1. Review of financial, economic and monetary developments and policy options

Financial market developments

Ms Schnabel reviewed the financial market developments since the Governing Council's previous monetary policy meeting on 27-28 October 2021 and put these developments into the context of the broader financial stability landscape, in line with the outcome of the ECB's strategy review.

In response to the discovery of Omicron, stock markets worldwide had suffered marked losses. The volume of put options on the EURO STOXX 50 had hit its highest level since the outbreak of the coronavirus (COVID-19) pandemic in March 2020, as investors looked for protection against further losses. At the same time, the ten-year US Treasury and euro area GDP-weighted sovereign yields had almost fallen back to the lows seen over the summer. They stood well below the levels observed at the Governing Council's October meeting.

These financial market developments could be interpreted in two ways. The first was that the market expected Omicron to have a materially larger impact on economic activity than previous mutations. However, model-based evidence showing a shock-decomposition of the recent decline in ten-year euro area OIS yields assigned only a fraction of the decline in yields to a deterioration in the economic outlook. Similarly, less than a third of the recent marked decline in oil prices was likely to reflect a reappraisal of the global growth outlook.

The second interpretation of recent financial market developments related to the fragile market conditions that prevailed when the news about Omicron broke. Since mid-October 2021, volatility in bond markets had been rising sharply and liquidity conditions in derivative markets had deteriorated measurably, amplifying the market reaction to the news of Omicron.

Two factors had contributed to this fragile market environment. One was the growing conviction among investors that the period of low inflation was over and that globally monetary policy would have

Page 1 of 23

to be tightened sooner than had been anticipated earlier in 2021. The second was the sensitivity of financial markets to such changes in the policy outlook after years of significant monetary policy accommodation.

In the United States, markets now assessed the chance of a rate hike at the Federal Reserve's meeting in May 2022 as well over one in two. A one-in-three chance of a rise was seen as early as March 2022. In the euro area, by contrast, expectations of "lift-off" - a first rate hike - had been pushed back compared with the Governing Council's previous meeting on 27-28 October 2021. Nevertheless, lift-off expectations remained far closer than they had been at the Governing Council meeting on 8-9 September 2021, and they had also become less volatile. Moreover, the gap that had opened in the autumn between the lift-off expectations priced in by markets and those indicated by the participants in the Survey of Monetary Analysts (SMA) was closing. In the SMA, the median expectation for lift-off had been brought forward by another two quarters, from the second quarter of 2024 to the fourth quarter of 2023 - only three quarters later than priced in by markets compared with six quarters in October 2021.

The divergence in expected policy cycles had continued to put significant downward pressure on the euro-US dollar exchange rate. The euro had depreciated by nearly another 3% against the US dollar since the Governing Council's previous monetary policy meeting and was currently down by 8% from its peak in late May 2021. The ECB's forward guidance remained a key factor behind the divergence in expected policy cycles. Although the relationship between expected inflation and expected policy rates had strengthened somewhat since the Governing Council meeting on 8-9 September 2021, it remained significantly weaker than before the COVID-19 pandemic. Also, looking at the relationship between expected policy rates and inflation surprises across advanced economies, the euro area stood out as a clear exception, with significant cumulative upside surprises to inflation having a limited impact on policy rate expectations.

Nevertheless, uncertainty around the future path of policy rates had increased, also in the euro area, which had contributed to the rise in market volatility. The risk distribution around the three-month EURIBOR had narrowed somewhat compared with the Governing Council's previous meeting on 27- 28 October 2021. However, it remained significantly larger than in July and clearly skewed to the upside. This risk distribution suggested investors were concerned that the high uncertainty about the inflation outlook could mean the conditions of the ECB's forward guidance might be met earlier than currently expected.

This view was corroborated when looking at inflation swap rates. Although these had come down from their multi-year highs in recent weeks, the current euro area forward inflation swap curve remained close to the 2% target. It stood well above the level that had been expected before the COVID-19 pandemic. Option markets, too, continued to price in a significant probability of inflation exceeding the

Page 2 of 23

ECB's target. They suggested around a 10% probability that inflation over the next five years would, on average, be above 3%, and about a 40% probability that inflation would be above 2%.

To understand how sensitive the market was to a shock like Omicron, it was important to look at the risk exposure that investors had previously built up in expectation that short-term rates and volatility would stay low for a long time. In equity markets, global equity funds had taken in more funds in 2021 than in the previous two decades combined, which had contributed to pushing equity valuation metrics to the tails of, or beyond, the 75th percentile of the historical distribution, in particular in the United States but also in the euro area. Vulnerabilities had risen substantially in the non-bank sector. For example, the liquidity, credit and duration risk of euro area investment funds had all increased notably since the start of the COVID-19 pandemic.

Similarly, in euro area sovereign and corporate bond markets, credit risk premia had been severely compressed over the past months despite much higher leverage. Prospects of higher risk-free rates had led to a decompression, albeit to varying degrees, with spreads generally remaining well below the levels observed before the pandemic. Moreover, with volatility elevated and safe assets in high demand, bond yields had actually fallen in almost all euro area Member States since the Governing Council's October meeting and had otherwise remained close to their October levels. Spreads had only increased due to a strong decline in German Bund yields, which themselves had fallen much more sharply than the OIS rate. The spread of the ten-year Bund yield over the equivalent OIS rate had declined below the extraordinary levels seen at the height of the pandemic in March 2020.

These developments highlighted the exceptional demand for safe assets as uncertainty about the policy outlook had increased. On the supply side, the available "free float" of bonds in the euro area had declined to very low levels. As a result, there had been a gradual and persistent deterioration in bond market liquidity across most euro area jurisdictions. Recently the Governing Council had decided to double the aggregate limit on the cash that counterparties could pledge under the Eurosystem securities lending programme. This had supported liquidity in the repo markets at a time when the demand for collateral had been rising and supply had been limited.

The global environment and economic and monetary developments in the euro area

Mr Lane reviewed the global environment and the recent economic and monetary developments in the euro area.

Regarding the external environment, Purchasing Managers' Index (PMI) data had signalled some slowing down of the world economy in the third quarter of 2021, owing to COVID-19-related restrictions and supply chain disruptions. The latest PMI data signalled a renewed improvement for the fourth quarter - especially in services but less so for manufacturing. Supply bottlenecks continued to

Page 3 of 23

restrain global activity and trade. Since the October monetary policy meeting of the Governing Council oil prices had decreased sharply (-12%), reflecting demand and supply effects. The euro exchange rate had declined only modestly in nominal effective terms (-0.4%), but had fallen visibly against the US dollar (-3%). Gas prices had increased amid heightened volatility, while metal prices had continued their downward trend.

Turning to developments in activity in the euro area, during the lockdown in the first quarter of 2021 there had still been a substantial gap between GDP and its pre-crisis level. However, much of this gap

• though not all - had been closed by the third quarter of 2021. A lot of the recovery during 2021 had been driven by private consumption, linked to the recovery in household spending on services that had followed the earlier recovery in manufacturing.

The nature of supply constraints had been shifting over time and these continued to weigh on activity. Manufacturing firms had been suffering from shortages of materials and equipment. According to the Industry Survey of the European Commission, these shortages had worsened in the fourth quarter of 2021. The lack of skilled labour had become a concern in parts of both the manufacturing and the services sectors.

Growth in disposable income had increased between the first and third quarters - reflecting a large recovery in real income. But in the fourth quarter real income was expected to drop, linked to the recent rise in energy prices. This implied a notable reduction in household real disposable income through a terms-of-trade effect, which was expected to dampen consumer spending in the short term.

As regards housing investment, confidence continued to be strong but constraints from the supply side were playing an increasing role. Investment in other machinery and equipment had exceeded pre- pandemic levels since the first quarter of 2021, while in the third quarter investment in transport equipment had still been substantially below pre-pandemic levels. According to the Survey on the Access to Finance of Enterprises (SAFE), the share of firms saying that they had obtained financing for fixed investment over the latest six-month period had continued to improve and had reached a level above the pre-pandemic average.

The recovery in the labour market continued to be strong. Although the unemployment rate had decreased further to the pre-crisis level of 7.3% in October, job retention schemes continued to support the labour market. Staff calculations indicated that the unemployment rate would be around 9% if workers in job retention schemes were added to the unemployed. In addition, the labour force continued to increase slightly but remained below pre-crisis levels. Employment and hours worked had been increasing in the third quarter but remained below pre-crisis levels, with some variation across countries. This signalled that the labour market was nowhere near back to normal. The job vacancy rate for the total economy had reached 2.6% in the third quarter, its highest level since the start of the data series. This increase was broad-based across sectors and reflected strong labour demand.

Page 4 of 23

The December 2021 staff projections foresaw a strong recovery in economic activity despite some near-term downward revisions owing to supply bottlenecks and the new pandemic wave. Economic growth in 2021 was seen to equal 5.1%, compared with 3.9% in the December 2020 projections.

Inflation was expected to remain higher for longer, owing to high energy prices as well as mismatches between supply and demand. But the narrative remained that bottleneck effects were expected to fade over time. Headline inflation was foreseen to fall below 2% as of the fourth quarter of 2022 and be equal to 1.8% in 2024. This reflected low energy inflation but robust core inflation, supported by the absorption of slack, increased labour costs and higher inflation expectations.

Looking at different forecasts over time, the June 2020 Eurosystem staff projections had foreseen only a partial recovery of the economy - whereas now in the December 2021 forecast the real GDP projection had returned to the pre-pandemic path. It was also very important to look at the labour market, where the December projections were returning to the pre-pandemic path. At 6.6% at the end of the projection horizon in 2024, the unemployment rate was forecast to be at a level not seen since the early 1980s. However, this was partly attributable to adverse demographic developments leading to a lack of workers and therefore stronger labour market pressures.

To address the high uncertainty surrounding the economic outlook, the December 2021 Eurosystem staff projections continued to include alternative pandemic scenarios.

Turning to developments in prices and costs, Harmonised Index of Consumer Prices (HICP) inflation had increased further from 3.4% in September to 4.1% in October and 4.9% in November (flash release), pushed up by another increase in energy inflation. Energy inflation had reached an all-time high in November - predominantly driven by oil and fuel prices - while gas and electricity had also played an important role. But there had also been a substantial rise in HICPX inflation, i.e. HICP inflation excluding energy and food, based on higher inflation for goods and services.

Price pressures had spread to more of the goods and services included in the HICP. The range of inflation rates across HICP items was currently very wide. Most indicators of underlying inflation had picked up quite a bit recently, but it remained difficult to disentangle how much of this increase reflected pandemic effects. These included base effects, bottlenecks - which were expected to fade eventually - and the indirect effects of imported energy. Because of the many special factors at work it was unclear to what extent these indicators were, at present, good indicators of underlying inflation. Wage pressures also remained relatively limited, which was an essential aspect for assessing underlying inflationary pressures.

Pipeline price pressures continued to build up. Owing to their lagged impact, this implied stronger upward pressure on non-energy industrial goods (NEIG) inflation in the future. At the same time, it was important to remember that goods represented only a relatively small fraction of the overall consumption basket underlying the HICP.

Page 5 of 23