As Covid-19 vaccinations are rolled out, some worry that people will jump the gun, and start taking the dangers of renewed contagion too lightly before the pandemic has been fully beaten back. Similar fears about misplaced economic optimism haunt central bankers — especially in the eurozone.
Like the vaccinated elderly British flouting lockdown rules, rising market interest rates reflect what is fundamentally good news: that the economy is on the cusp of a strong recovery (or in the case of senior parole-skipping, that the danger of exposure to coronavirus has been significantly reduced).
This could be premature anywhere, but especially in continental Europe, where rising bond yields have partly spilled over from US markets reacting to the massive fiscal stimulus that President Joe Biden is seeking to push through Congress.
Chiara Zangarelli, research analyst with Nomura, said that while European nominal yields remain at low levels, the recent rise is “notable . . . with most countries still under lockdown, vaccinations proceeding at a slow pace and inflation rising mainly for temporary reasons”.
In what must be the most dovish recent speech from the European Central Bank, its executive board member Fabio Panetta last week warned that “we are already seeing undesirable contagion from rising US yields . . . that is inconsistent with our domestic outlook and inimical to our recovery”. The market’s effective tightening of financial conditions since December, when the ECB last tweaked its stance, “is unwelcome and must be resisted”, he added.
Analysts have duly noted the logical implication: a looser monetary stance in order to offset the tightening of financial conditions. “Panetta is explicitly calling for additional accommodation to lower bond yields,” noted Frederik Ducrozet, a Pictet strategist.
That is not all. While putting a dovish thumb on the scale in the debate about short-run monetary decisions, Panetta also issued a longer-term challenge to his more hawkish colleagues.
In his speech, he made observations similar to those issued by Federal Reserve policymakers ahead of shifting to a more aggressive monetary policy strategy last year. The previous crisis showed, he said, “that it is hard to lift inflation dynamics without demand testing potential more dynamically” — jargon for keeping the foot on the accelerator until prices are clearly picking up.
He added that “a high-pressure economy helps reabsorb lower-skilled workers into the labour market [as well as] strengthening business investment” — in other words, pushing demand aggressively towards the economy’s potential may itself help boost that potential.
Such remarks echo the lessons former and current Fed chairs Janet Yellen and Jay Powell drew from the last cycle. This evolution in their and their colleagues’ thinking goes a long way to explaining why the ECB’s US counterpart now worries less about overheating and has promised to tolerate above-target inflation after a period of undershooting. Panetta’s similar focus will tug internal discussions in the ECB’s own ongoing policy review in the same direction.
The pandemic, and the widely shared worry that it will permanently “scar” the economy’s supply capacity, make those arguments more urgent. “Policy should not accept [permanent scarring] as a reality which imposes new supply constraints,” Panetta said, “but rather explicitly set out to test those constraints.”
Urgency does not mean the arguments will necessarily get traction, however. Zangarelli cautioned that there was “a big divide within the ECB between dovish and hawkish members”. In the short run, however, she thinks “they have to react” to the “unwarranted” rise in bond yields.
That could bring the central bank very close to something it has officially forsworn: targeting of specific levels of bond yields, or “yield curve control”. Panetta’s speech calls for “anchoring” market yields. “What he is saying is very similar to what yield curve control could look like,” said Zangarelli.
“This could lead to interesting debates” internally, said Ducrozet. For investors, however, action matters more than words: yield curve control by any other name would smell as sweet.