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Robust euro zone rebound could let ECB start winding down PEPP from Q3, Knot says

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Robust euro zone rebound could let ECB start winding down PEPP from Q3, Knot says 1

By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) -The euro zone economy is on course for a robust recovery in the second half of the year that could allow European Central Bank to start phasing out its emergency bond purchases in the third quarter, Dutch central bank chief Klaas Knot said.

A spreading pandemic, lockdown and a slow vaccination campaign may all weigh on the outlook over the next several months, but a string of factors point to potentially positive surprises after mid-year, once the pandemic is brought under control, Knot told Reuters in an interview.

"If the economy develops according to our baseline, we will see better inflation and growth from the second half onwards," Knot said. "In that case, it would be equally clear to me that from the third quarter onwards we can begin to gradually phase out pandemic emergency purchases and end them as foreseen in March 2022."

The ECB stepped up bond buying last month under its 1.85 trillion-euro Pandemic Emergency Purchase Programme, worried that rising yields, mostly a spillover from a U.S. Treasury selloff, could derail the bloc's eventual recovery.

Yields have levelled off since then. Inflation-adjusted yields are back near their early-year lows, levels Knot said he was comfortable with.

"To the extent that higher nominal yields are driven by better inflation and growth prospects, to me that's entirely benign," he said. "If real rates are roughly constant, it means that higher nominal rates are entirely due to higher inflation expectations and that is something I'm comfortable with."

RECOVERY

Economic weakness is now concentrated in services directly affected by lockdowns. The rest of the economy is adjusting better than many expected, with manufacturing and trade already at or above their pre-crisis levels.

The International Monetary Fund this week upgraded its forecast for euro zone growth to 4.4% from 4.2%. Whatever output is lost due to lingering lockdowns, will be more than made up once the economy can re-open, the IMF said.

"There is very good reason to expect a robust recovery in the second half of the year," Knot said. Consumers are eager to spend their pent up savings, more fiscal stimulus is coming and the external environment has improved sharply, he said.

"The deterioration is focused on the short term but hasn't changed the outlook beyond the short term all that much," Knot, one of the more conservative members of the ECB's Governing Council, said.

The rebound could lead to a surge in inflation, as the ECB predicted, but given ample slack in the labour market, it is likely to be temporary and price growth will remain below target for years, Knot said.

He also played down concerns about underwhelming fiscal support, arguing that the government response is better than it first appears.

Governments are already debating more support, automatic stabilisers remain in place and the European Union's 750 billion-euro fiscal package will lift the bloc's growth potential.

Once recovery starts to take hold and investors buy into risk-bearing instruments, nominal bond yields will inevitably move higher and "no amount" of ECB buying can completely undo that.

Even if the ECB can start winding down its emergency measures this year, inflation remains too low for the bank to adjust other instruments, Knot added.

"The inflation outlook does not provide any case for tightening our standing instruments, like our forward guidance on rates or the APP," Knot said. "Exiting our emergency measures does not equate to exiting our accommodative monetary stance."

For a transcript of the interview, click on

(Reporting by Balazs Koranyi, editing by Larry King)

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