Banco de España : Account of the monetary policy meeting of the Governing Council of the European Central Bank (28-29 October 2020) (178 KB)

26 November 2020

Account of the monetary policy meeting of the Governing Council

of the European Central Bank

held in Frankfurt am Main

on Wednesday and Thursday, 28-29 October 2020

………………………………………..…….

Christine Lagarde

President of the European Central Bank

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 9-10 September 2020.

Financial markets had been driven by two opposing forces. On one side, reduced risks of a contested presidential election in the United States and expectations of a large fiscal stimulus programme under a potential Biden presidency had boosted risk sentiment and revived the reflation trade. On the other side, renewed lockdown measures in different countries on the back of a surge in new coronavirus (COVID-19) cases, especially in the euro area, were increasingly reflected in asset price valuations.

Unlike in spring, however, so far there had been no widespread flight into safe-haven assets. Instead, euro area sovereign bond spreads had compressed further and corporate bond spreads had remained stable. Equity markets, where policy support was least direct, had experienced a marked correction. Risk premia in euro area equity markets had increased and were estimated to have pulled euro area stock prices down by nearly 10% since the Governing Council's previous monetary policy meeting, although this decline had been partly mitigated by a rise in short-term earnings growth expectations.

In the United States, stock markets had increased by 5% since opinion polls started to point to a victory for the Democratic Party in the presidential election on 3 November 2020. Improved risk sentiment had also put renewed downward pressure on the US dollar, with positioning data pointing to risks of further US dollar depreciation. In bond markets, heightened expectations of fiscal stimulus in the United States had led to a notable steepening of the US Treasury curve, also reflecting rising inflation expectations.

In the euro area, by contrast, inflation expectations had trended lower since the Governing Council's previous monetary policy meeting, thereby also putting downward pressure on yields. The euro area risk-free curve was close to its flattest ever level, while the euro area GDP-weighted sovereign yield curve had shifted down further since the September monetary policy meeting. The curve was now measurably below the pre-pandemic level and firmly in negative territory up to the ten-year maturity. There was not a single euro area country that was not benefiting from negative yields, in most cases extending out to the three-year maturity.

The degree of accommodation currently embedded in euro area sovereign bond markets was practically unprecedented since the global financial crisis, both in its scale and its breadth across countries. The dispersion across euro area ten-year sovereign yields was at its pre-pandemic level, which itself had been far below the levels observed in previous years due to the substantial convergence in bond spreads in those countries that had been hit hardest by the sovereign debt crisis.

Market participants had pointed to three main reasons to explain why the spreads had fallen further. The first reason related to risk sentiment. There had been a strong negative correlation between euro area sovereign spreads and US stock price developments in the weeks before the current meeting. The second reason

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related to expectations of further monetary policy support by the ECB. The third reason related to the first successful bond issuance under the European Commission's temporary programme of Support to mitigate Unemployment Risk in an Emergency (SURE), which had met with unprecedented demand. This provided tangible evidence of how the common European response to the crisis had helped to alleviate pressure on euro area sovereign funding and hence financing conditions. Therefore, contrary to the early phase of the crisis, the joint fiscal and monetary policy responses in the euro area had succeeded in providing firm protection against the risks of fragmentation and of an unwarranted tightening of financial conditions.

This was also clearly visible in corporate bond markets. In recent weeks, corporate credit spreads had largely resisted upward pressures despite a deteriorating growth outlook. The resilience in corporate bond markets likely also reflected the fact that firms had built up significant liquidity buffers over the past several months, limiting the extent to which they would have to rely on external credit in the event of a renewed collapse in business activity. At present, euro area firms' cash coverage was nearly four times higher than at the height of the global financial crisis.

Finally, growing excess liquidity was increasingly putting downward pressure on the term money market and commercial paper rates. Since early October 2020, the three-month EURIBOR had traded below the deposit facility rate, and corporates could issue three-month commercial paper at rates close to the deposit facility rate, providing an important liquidity backstop for corporates, with rates falling even faster at longer tenors.

All in all, financial market conditions remained very favourable across market segments, but vulnerabilities remained in the face of the exceptionally high uncertainty surrounding the future evolution of the pandemic- related crisis.

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

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

Regarding the external environment, the global economy had come back rapidly early in the third quarter, after the end of the lockdowns. Developments in the global composite output Purchasing Managers' Index (PMI), excluding the euro area, indicated that the recovery in activity was quite strong up to July but had flat-lined in September. Retail sales had recovered strongly around the world, while global consumer confidence had risen from its lowest level but still remained very weak. Turning to trade, high-frequency data pointed to a strong rebound in the third quarter of 2020 and early indications for the fourth quarter were also positive. Global financial conditions were broadly unchanged in both advanced and emerging economies.

Oil prices had increased slightly, by 1.8%, since the Governing Council's September monetary policy meeting, to stand at USD 39.8 per barrel on 26 October 2020, after trading in a narrow range. The euro had remained broadly stable against the US dollar (+0.4%), which continued to have a unique role in global trade, and in nominal effective terms (+0.2%) since the September meeting.

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Turning to the euro area, output had rebounded strongly in the third quarter of 2020. At the same time, clear risks to GDP growth had emerged for the fourth quarter of 2020, linked primarily to the latest news about the plans for more severe lockdowns from November onwards.

The latest data supported the view that the recovery had been losing steam in the euro area. Industrial output had bounced back vigorously until August, when growth had decelerated to only 0.7% month on month. Retail sales had also softened in the summer months, and manufacturing and services PMIs for September and October suggested that the pace of recovery across the euro area had slowed.

Looking ahead, the outlook for services was gloomy, while industry appeared more resilient. Household savings were expected to remain high, but income support remained important for consumer confidence over the coming months in order to protect the economy. The outlook for business investment was depressed by weak demand, low revenues and low profitability.

Turning to euro area trade, exports and imports of goods had continued their recovery. Looking ahead, PMI new export orders signalled a continuation of the recovery in euro area goods exports, whereas the rebound in euro area services exports seemed to be fading, particularly in countries which relied heavily on tourism.

With respect to euro area labour markets, employment was expected to contract further and a large share of jobs were at risk. The PMI composite employment index had recovered strongly since spring, but remained below 50 in October. Since the start of the pandemic, the weakening in employment conditions had been particularly marked in labour-intensive sectors such as accommodation, food, transportation and warehousing. The euro area unemployment rate, which had increased from 7.2% in February to 8.1% in August, likely underestimated the ongoing adjustment in the euro area labour market.

Turning to nominal developments, HICP inflation fell to -0.3% in September, while HICP inflation excluding energy and food declined to a new low of 0.2% in September. The decrease in headline inflation, from -0.2% in August to -0.3% in September, reflected lower inflation not only for energy but also for non-energy industrial goods and services. Measures of underlying inflation were also weakening.

Regarding wage growth, euro area compensation per employee growth and compensation per hour growth had diverged strongly due to large changes in hours worked. Negotiated wage growth, which was not directly affected by changes in hours worked, had declined only gradually, with the few wage agreements that had been concluded over recent months pointing to lower wage increases.

Looking at survey-basedlonger-term inflation expectations, as reported in the latest ECB Survey of Professional Forecasters (SPF), inflation expectations five years ahead had remained broadly stable at around 1.6%-1.7%. Since the September monetary policy meeting, market-based indicators of longer-term inflation expectations had halted their recovery and remained broadly stable around their pre-pandemic levels. The five-year forward inflation-linked swap rate five years ahead stood at 1.16% on 26 October 2020.

As regards financial conditions in the euro area, the EONIA forward curve remained slightly inverted, but there were no firm expectations of an imminent rate cut. Longer-termrisk-free rates remained broadly unchanged at low levels despite upward movements in US rates. Sovereign spreads had declined further amid expectations

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