LONDON - The European Central Bank meets on Thursday and one topic will dominate: what to do about rising sovereign bond yields which if left unchecked could derail efforts to get a coronavirus-hit economy back on track. Germany's 10-year borrowing costs jumped 26 basis points in February, the biggest monthly rise in over three years, with similar moves seen across the euro area. Policymakers from president Christine Lagarde to chief economist Philip Lane have expressed unease. Markets want to know the game plan. Here are five key questions on the radar. 1. What will the ECB do to contain rising bond yields? The ECB shouldn't hesitate to lift bond buying volumes and use the full firepower of the 1.85 trillion euro ($2.2 trillion) Pandemic Emergency Purchase Programme (PEPP) if needed, says board member Fabio Panetta. Economists agree but policymakers are divided. Just under 1 trillion euros of the PEPP is still unused. Buying slowed recently, perhaps due to technical factors. Still higher government borrowing costs, threatening to spill over to corporates and consumers, create a headache for an ECB grappling with a weak economy. "Is the ECB fully aware of the risks?," said ING Research global head of macro Carsten Brzeski. "And if they are, are they willing to be more precise about what they are prepared to do -- will they act with advanced PEPP purchases?" GRAPHIC: The ECB's pandemic stimulus programme - /zb_users/upload/20210308/fskf25direo49.png 2) What exactly is the ECB watching to assess financial conditions? Lagarde will be pressed for clarity on this. She has voiced concern about rising nominal yields. Remarks from other officials and the last ECB minutes put emphasis on the real or inflation-adjusted component of yields as a key determinant of financial conditions. Both have risen this year, but real yields less so. Lane focuses on the GDP-weighted sovereign yield curve and the overnight index swap (OIS) curve. A clearer idea of which is key would give markets a better sense of policymakers' pain threshold. GRAPHIC: Which yield is key? - /zb_users/upload/20210308/fbywskjmqhs50.png 3) How far does the ECB expect inflation to rise this year? Accelerating inflation, which could exceed the near 2% target in coming months, means the ECB will likely increase its 2021 inflation forecast. Lagarde may stress that a recent pick-up in prices is driven by one-off factors and should fall back. But there are differing opinions among policymakers. Bundesbank chief Jens Weidmann believes the ECB will have to "act accordingly" if inflation rises. "There are more mixed views on inflation - ECB staff and Lane think inflation is subdued but this is not shared by the hawks, with Weidmann recently highlighting that German inflation was likely to go through 3% this year," said Jacob Nell, head of European economics at Morgan Stanley. GRAPHIC: Accelerating inflation? - /zb_users/upload/20210308/bqg12qqnwzn51.png 4) What will the ECB say about the economic outlook? Economists expect the medium-term outlook to remain broadly unchanged, with a recovery forecast in the second half of 2021. Lagarde, however, may stress short-term downside risks as the bloc battles the coronavirus pandemic and lockdowns. The economy is almost certainly in a double-dip recession as the services industry suffers, but hopes for a wider vaccine rollout has driven optimism to a three-year peak, a survey showed last week. GRAPHIC: Euro zone economic surprises stay positive in 2021 - /zb_users/upload/20210308/hjpx2evyya352.png 5) Is the ECB relieved that Draghi is Italian PM? Lagarde is unlikely to comment on politics in Italy, where her predecessor Mario Draghi just became prime minister. But a fall in Italian borrowing costs on his appointment is good news and eases pressure on the ECB. The Italian/German 10-year bond yield gap narrowed to the tightest levels since 2015 in February; recent bond turbulence hasn't hurt too much. The trusted Draghi has promised sweeping reforms to revitalise a battered economy. His strongly pro-European stance is seen as a positive for Italy and the euro project. GRAPHIC: Italian bond spread during the COVID-19 crisis - /zb_users/upload/20210308/rqo2jc5svh453.png REUTERS
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