ECB to kickstart policy normalisation, BOJ patient
The European Central Bank is likely to join the policy normalisation bandwagon earlier than the BOJ.
Group Research - Econs, ----Select-----17 Feb 2022
  • We maintain Eurozone’s 2022 growth forecast and dial up inflation
  • ECB will kickstart policy normalisation this year on a tight labour market and high inflation
  • A surge of Omicron-related challenges will hinder Japan’s 1Q growth outlook
  • It is premature to expect BOJ policy normalisation because of subdued wage growth and low inflation
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High vaccination rates across the Eurozone member countries helped keep hospitalization rates in check but were insufficient to contain the spread of Covid in 4Q21 and early this year. Countries reintroduced restrictions that were broadly milder and localized. The gradual easing of these measures laid the ground for sequential improvement in activity and mobility markers from 2Q22 onwards.  

As global trends suggest, the current wave of infections and its impact on economic activity is likely short-lived after a weak start to the year. Lead supply indicators also point to easing bottlenecks and logistical disruptions, which should bode well for the zone’s production and export trends. The fall in the unemployment rate, if accompanied by a pickup in the labour participation rate, will be a catalyst for a more durable consumption revival. For now, the recovery in consumer confidence trails the lift-off in business sentiments. This likely reflects pandemic-led caution and the lack of strong wage growth despite rising job vacancies and anecdotal labour shortages.

Financing conditions are favourable. The Next Generation EU (NGEU) fund outlays will add momentum to investment growth. Factoring these dynamics, we maintain our 2022 growth forecast at 4% yoy, whilst dialling up 2023 to 3%.

Elevated and persistent inflation is turning out to be a key headwind, notwithstanding higher tolerance after last year’s tweaks to the policy target framework. In Jan22, inflation jumped to 5.1% yoy, a record high, quickening from 4.6% in 4Q21 and sharply higher than 0.3% in 4Q20.  Energy prices have rallied, spilling over to transport and utilities, alongside sticky housing components. Job vacancy rates are up, implying tightness in labour markets, leaving the door open for second-round effects if wage growth matches the commensurate improvement in demand. Given elevated energy prices and a tight labour market, inflation is only likely to peak in second half of the year when base effects fade. We expect full-year inflation to average 4% vs 2.6% in 2021. Persistently high inflation carries the risk of stoking inflationary expectations as well as hurt to real spending power, just as activity returns to pre-pandemic levels.

With inflation at a record high and growth expected to return to a firmer footing on easing restrictions, European policymakers are coming around to partially unwinding the emergency policy settings of the past two years. While rates were left unchanged in February, the press conference and introductory speech carried early stirrings of a change in stance. Growth outlook was seen as ‘broadly balanced’, and inflation assessment was cautious, highlighting that these risks were “tilted to the upside”. ECB chief Lagarde did not commit to her past insistence that rates would not be raised in 2022, leaving the door open for policy normalisation this year.

As the ECB turns cautious on inflation risks, high energy prices and policy normalization by its Western counterparts, the stage is being set for a gradual withdrawal of the accommodative measures. A formal shift in guidance before mid-year, marked by an upward revision in the 2022-2023 inflation forecasts, underscoring the policymakers’ view that price pressures might prove to be more pervasive than previously assumed. As per our base case, the ECB will end asset purchases in 3Q22, lift the deposit facility rate twice from minus 0.50% in late 3Q to 0% in 4Q, and increase the refi rate in small increments in 2023. Imminent normalisation prospects and rally in UST yields have led to a repricing in money market rates as well as longer-tenor bond yields. Even as the hawks gain an upper hand, the ECB will be keen to manage expectations to ensure financial conditions don’t tighten prematurely.



GDP growth forecast for this year is trimmed to 2.2% from 2.5% and revised up to 1.8% from 1.2% for 2023. The near-term growth outlook is dampened by the resurge of Covid. Due to the rapid spread of Omicron, daily infection numbers in Japan have hit 100k, exceeding four times the previous peak recorded in the summer of 2021. Prime Minister Fumio Kishida’s government re-imposed the quasi-state-of-emergency measures and closed international borders. Since January, Google mobility data for retail and recreation activities have fallen back into the negative territory. A QoQ contraction in private consumption appears inevitable in 1Q.

The medium-term recovery prospect remains unchanged. Global experience suggests that Omicron infections decline rapidly after a massive month-long surge. Some European countries have declared the end of the pandemic and scrapped all the restriction measures. Experts predict the current Omicron wave will peak in February in Japan, followed by an easing of restriction measures and a rebound in consumption in 2Q. Nonetheless, the rollout of Covid vaccine boosters is far slower in Japan than in Europe. Only 9% of the population have received the booster doses in Japan as of mid-February, compared to 50-60% in Denmark, France, Germany, and the UK. It will still take time to remove all restrictions and achieve a full recovery in consumption.

The outlook for external demand recovery remains intact. Automobile exports have started to pick up since 4Q21, thanks to the dissipation of supply chain disruptions in ASEAN and the easing of auto part shortage for Japanese carmakers. Expect a further recovery towards the latter part of this year, as the global auto chip shortage continues to ease along with the massive expansion in semiconductor investment. Meanwhile, a relatively cheap yen should help to bolster Japanese exporters’ earnings and strengthen their competitiveness. The yen has depreciated 10% versus the dollar over the past 12 months, or 7% on the NEER basis.

Inflation forecasts are lifted to 0.9% for 2022 and 2023, up from 0.5% previously. Headline and core CPI inflation have turned marginally positive since 4Q21, largely driven by the food and public utility items. The core-core CPI excluding fresh food and energy has remained in the negative territory. In the absence of a full recovery in the labor market and a substantial rise in wage growth, underlying inflation will likely remain subdued through this year and early-2023. Our forecast revision mainly reflects the higher-than-expected imported inflation caused by energy price increases and yen depreciation.

The Bank of Japan is in no hurry to follow other DM central banks to normalise monetary policy. Under the existing policy framework of Quantitative and Qualitative Easing with Yield Curve Control, the BOJ promises to continue expanding its monetary base until core CPI exceeds 2% and stably stays above this level. Despite higher energy prices and yen weakness, it still appears difficult to achieve the 2% inflation target during our forecast period. During the 2006-07 policy normalisation cycle, the BOJ ended QE in Mar06 and hiked rates by 25bps each in Jul06 and Feb07. CPI turned marginally positive in 2006 and fell back to zero in 2007. BOJ governor Haruhiko Kuroda, the key designer of the QQE scheme introduced in 2013, will take extra care to avoid premature/rapid policy moves that risk a return of deflation.

In our view, minor policy tweaks – widening the range of 10Y JGB yield target by 5-10bps – are possible over the next 12 months, should market yield persistently test the upper ceiling of the BOJ’s ±0.25% target amid a synchronous rise in global yields. But significant policy adjustments – ending the negative short-term policy rate, directly raising the 10Y yield target, or shifting to anchor the 5Y JGB yield – may only come in 2H23 at the soonest, after Kuroda completes his 10-year term in April.

Related reports:

Eurozone & Japan: Better times ahead

Eurozone: ECB Strategy review affirms dovish course

Japan: A new hope

Eurozone & Japan: Delta and cautious reopening

To read the full report, click here to Download the PDF.

Ma Tieying 馬鐵英, CFA

Economist - Japan, South Korea, & Taiwan 經濟學家 - 日本, 南韓及台灣
[email protected]

Radhika Rao

Senior Economist – Eurozone, India, Indonesia
[email protected]

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