Central Bank Dilemma: Balancing Balance Sheet Strategies Amid Cautious Voices and Inflation Pressures

But there are also more cautious voices on the topic. Just as Lagarde pointed out in yesterday’s panel, interest rates remain the ECB’s primary monetary policy tool. In another background report by Econostream released in the afternoon, ECB officials signalled that the current passive run-off was sufficient, and especially speeding it up via the changes to the PEPP guidance and/or reinvestments would unnecessarily risk financial stability.

 

After all, the possibility to flexibly reinvest PEPP holdings is one of the main tools that the ECB still has to quickly react to spread widening pressures in bond markets.

At some point the ECB has to decide on the balance sheet size it wants to target, which goes hand-in-hand with an ongoing review of the ECB’s operational framework. Yesterday, Lagarde flagged that this work could hopefully be completed in the next “six to nine months”. This indicates some upside risk to previous communication which saw the review being concluded by the end of the year.

 

Today's events and market view

Inflation remains the central banks’ one needle in the compass that dictates their policy nowadays. This puts the focus squarely on today’s inflation readings out of Germany and Spain. German headline and core rates are seen higher on the back of base effects and statistical tweaks. Spain’s headline rate is seen falling below the 2% level but, more importantly, the core rate is seen to come down only marginally.

 

Alongside Italy’s data from yesterday this should already give a good idea of where tomorrow’s eurozone reading is headed – and it should signal no let up in the pressure on central banks to continue to act forcefully.

 

In this set-up yield curves will remain inverted for some time. Markets will see the softness in wider data, such as in yesterday’s eurozone credit growth which shows that policy transmission is working. Still, if there is anything that could turn the market it is surprises in the inflation data, which markets might be quicker to extrapolate even if central banks themselves might want to see confirmation from more than just one reading.

 

In other data we will get the initial jobless claims out of the US, pending home sales, as well as a third reading for first quarter GDP growth.