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Meeting of 15-16 December 2021

Account of the monetary policy meeting of the Governing Council of the European Central Bank held in Frankfurt am Main on Wednesday and Thursday, 15-16 December 2021

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 27-28 October 2021 and put these developments into the context of the broader financial stability landscape, in line with the outcome of the ECB’s strategy review.

In response to the discovery of Omicron, stock markets worldwide had suffered marked losses. The volume of put options on the EURO STOXX 50 had hit its highest level since the outbreak of the coronavirus (COVID-19) pandemic in March 2020, as investors looked for protection against further losses. At the same time, the ten-year US Treasury and euro area GDP-weighted sovereign yields had almost fallen back to the lows seen over the summer. They stood well below the levels observed at the Governing Council’s October meeting.

These financial market developments could be interpreted in two ways. The first was that the market expected Omicron to have a materially larger impact on economic activity than previous mutations. However, model-based evidence showing a shock-decomposition of the recent decline in ten-year euro area OIS yields assigned only a fraction of the decline in yields to a deterioration in the economic outlook. Similarly, less than a third of the recent marked decline in oil prices was likely to reflect a reappraisal of the global growth outlook.

The second interpretation of recent financial market developments related to the fragile market conditions that prevailed when the news about Omicron broke. Since mid-October 2021, volatility in bond markets had been rising sharply and liquidity conditions in derivative markets had deteriorated measurably, amplifying the market reaction to the news of Omicron.

Two factors had contributed to this fragile market environment. One was the growing conviction among investors that the period of low inflation was over and that globally monetary policy would have to be tightened sooner than had been anticipated earlier in 2021. The second was the sensitivity of financial markets to such changes in the policy outlook after years of significant monetary policy accommodation.

In the United States, markets now assessed the chance of a rate hike at the Federal Reserve’s meeting in May 2022 as well over one in two. A one-in-three chance of a rise was seen as early as March 2022. In the euro area, by contrast, expectations of “lift-off” – a first rate hike – had been pushed back compared with the Governing Council’s previous meeting on 27-28 October 2021. Nevertheless, lift-off expectations remained far closer than they had been at the Governing Council meeting on 8-9 September 2021, and they had also become less volatile. Moreover, the gap that had opened in the autumn between the lift-off expectations priced in by markets and those indicated by the participants in the Survey of Monetary Analysts (SMA) was closing. In the SMA, the median expectation for lift-off had been brought forward by another two quarters, from the second quarter of 2024 to the fourth quarter of 2023 – only three quarters later than priced in by markets compared with six quarters in October 2021.

The divergence in expected policy cycles had continued to put significant downward pressure on the euro-US dollar exchange rate. The euro had depreciated by nearly another 3% against the US dollar since the Governing Council’s previous monetary policy meeting and was currently down by 8% from its peak in late May 2021. The ECB’s forward guidance remained a key factor behind the divergence in expected policy cycles. Although the relationship between expected inflation and expected policy rates had strengthened somewhat since the Governing Council meeting on 8-9 September 2021, it remained significantly weaker than before the COVID-19 pandemic. Also, looking at the relationship between expected policy rates and inflation surprises across advanced economies, the euro area stood out as a clear exception, with significant cumulative upside surprises to inflation having a limited impact on policy rate expectations.

Nevertheless, uncertainty around the future path of policy rates had increased, also in the euro area, which had contributed to the rise in market volatility. The risk distribution around the three-month EURIBOR had narrowed somewhat compared with the Governing Council’s previous meeting on 27-28 October 2021. However, it remained significantly larger than in July and clearly skewed to the upside. This risk distribution suggested investors were concerned that the high uncertainty about the inflation outlook could mean the conditions of the ECB’s forward guidance might be met earlier than currently expected.

This view was corroborated when looking at inflation swap rates. Although these had come down from their multi-year highs in recent weeks, the current euro area forward inflation swap curve remained close to the 2% target. It stood well above the level that had been expected before the COVID-19 pandemic. Option markets, too, continued to price in a significant probability of inflation exceeding the ECB’s target. They suggested around a 10% probability that inflation over the next five years would, on average, be above 3%, and about a 40% probability that inflation would be above 2%.

To understand how sensitive the market was to a shock like Omicron, it was important to look at the risk exposure that investors had previously built up in expectation that short-term rates and volatility would stay low for a long time. In equity markets, global equity funds had taken in more funds in 2021 than in the previous two decades combined, which had contributed to pushing equity valuation metrics to the tails of, or beyond, the 75th percentile of the historical distribution, in particular in the United States but also in the euro area. Vulnerabilities had risen substantially in the non-bank sector. For example, the liquidity, credit and duration risk of euro area investment funds had all increased notably since the start of the COVID-19 pandemic.

Similarly, in euro area sovereign and corporate bond markets, credit risk premia had been severely compressed over the past months despite much higher leverage. Prospects of higher risk-free rates had led to a decompression, albeit to varying degrees, with spreads generally remaining well below the levels observed before the pandemic. Moreover, with volatility elevated and safe assets in high demand, bond yields had actually fallen in almost all euro area Member States since the Governing Council’s October meeting and had otherwise remained close to their October levels. Spreads had only increased due to a strong decline in…

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