Bundesbank President Jens Weidmann says financing conditions for firms, households and general government play a crucial role. “These stake out the path the PEPP needs to follow if it is to counteract the downward pressure on inflation brought about by the pandemic.” In December 2020, the Governing Council of the ECB explicitly linked asset purchases under the pandemic emergency purchase programme (PEPP) to the objective of preserving favourable financing conditions, thereby supporting the flow of credit to all sectors of the economy, underpinning economic activity and safeguarding medium-term price stability, according to Mr Weidmann. At the same time, he pointed out that the ECB Governing Council’s assessment of financing conditions is a holistic one, assessing not just a single variable – government bond yields, say – but a whole raft of factors.

Analysing exactly how changes came about

But there’s more to it than just glancing at the indicators, Mr Weidmann said: if they flag changes, the job of central banks is to analyse exactly how those changes came about. After all, he noted, monetary policymakers don’t always need to act if capital market interest rates pick up. “If, for example, nominal interest rates rise because inflation expectations are approaching our inflation target, this would be a welcome development since it would indicate that our monetary policy measures are having the desired effect,” Mr Weidmann remarked. Other economic fundamentals might improve, too, causing real interest rates to rise. “This might be read in isolation as a deterioration in financing conditions. A holistic assessment, though, would reveal it to be nothing more than a side effect that does not impair the improvement in the economic outlook,” Mr Weidmann said. “I believe that financing terms should be able to evolve in line with the economic recovery in the euro area. It’s not a matter of using monetary policy to cement a particular interest rate level. Instead, a premature deterioration should be prevented so as to counteract the pandemic’s downward pressure on medium-term price developments.”

Euro area government bonds saw their yields increase somewhat recently. In the case of Bunds, this upswing was chiefly due to the interest rate hike in the United States, Mr Weidmann said, but the brightened macroeconomic outlook in the euro area likewise played a part in this. He noted that the Governing Council of the ECB saw the risk of the rise in risk-free interest rates and government bond yields in the year to date spilling over into other areas. A premature tightening of financing terms could put a strain on the economic recovery and set the euro area back as we head towards price stability, remarked Mr Weidmann, which is why the PEPP purchases during the second quarter will now be conducted in a way that makes them much more extensive than in the first few months of this year, allowing the ECB Governing Council to use the flexibility that the PEPP offers. This does not change the PEPP’s maximum envelope.

Economic outlook depends on evolution of pandemic

According to the Bundesbank President, the economic outlook currently depends, above all, on the evolution of the pandemic, making it equally uncertain. “Once the pandemic is under control and the official and voluntary measures to contain it are gradually eased, the euro area economies should see a swift recovery,” Mr Weidmann stated. “Given that infection rates are rising sharply at the moment, it may be a while longer than assumed in the March projections before containment measures can be relaxed. This would also delay the economic recovery,” he said. “In this scenario, the projected GDP growth rate for the euro area in 2021 might no longer be achievable. But even so, the activity level in the economy could hit the level foreseen in the March projections at the end of this year.”

Political pressure on central banks could increase

In his speech, Mr Weidmann emphasised that it would be reckless to rule out the possibility of central banks having to contend with stronger inflationary forces again in the future. The sharp rise in government debt could make it increasingly difficult for them to change their expansionary stance in a timely manner, he said, because they may come under growing political pressure to ensure the sustainability of government debt by maintaining an accommodative monetary policy for longer than is needed to safeguard medium-term price stability. “And in order to avoid raising false expectations, we need to make one thing clear today: the emergency monetary policy measures must not be permitted to persist indefinitely. They need to remain closely linked to the crisis and come to an end once the pandemic is over,” Mr Weidmann concluded.