Interpreting Yesterday’s ECB Decision

on Dec 11, 2020
Updated: Dec 19, 2022

The much-awaited ECB monetary policy decision is finally behind us. The central bank announced plenty of new measures to support banks and the economies in the Euro area, but it failed to surprise markets. 

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More precisely, one can say that the ECB under delivered if judging only by the initial reaction of the EURUSD exchange rate. How can it be possible for the Euro to rise on much more easing from the ECB? Once again, it is about the difference between what was priced in and what was delivered.

ECB December 2020 Decisions

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Right from the start, the ECB was disappointed by extending the PEPP program (i.e., its bond-buying program during the pandemic) only until March 2020, instead of June. While expanding it by another EUR500 billion, it actually sent a hawkish signal by reducing the extension period. By underdelivering, even such small differences mean a lot for currency market participants.

Another way the ECB under delivered yesterday comes from the adjusted terms for the Targeted Long-Term Refinancing Operations (TLTROs). Indeed, the central bank improved the terms, but it made it more challenging for banks to have access to the improved terms. In other words, not many banks will qualify. Hence the decision is not as constructive as one would have liked.

Finally, the true blowout of yesterday’s decision came from the staff projections. For 2023, the ECB staff projections for the core inflation are at 1.2%. This is a big problem for the ECB’s credibility because let us not forget, the ECB’s mandate is to bring and keep inflation below or close to two percent. By projecting such low inflation, the ECB is literally at the risk of shooting itself in the foot because it will be close to impossible for inflation expectations to rise to the target. At the same time, it undermines the effectiveness of yesterday’s “package.”

By the time the press conference ended, the EURUSD was at the highs, trading 1.2160, close to last Friday 1.2175 highs. Lagarde mentioned the high exchange rate, but only talking about it is not going to do well for inflation expectations.

Even if the Euro reverses, one cannot escape the filling that the ECB missed big on its chance of delivering a strong signal to the markets. After all, the Fed comes in the middle of next week, and it will raise the bar much higher.

Or, maybe, this is exactly why the ECB under delivered? To see what the Fed does first, and then adjust?