Europe | Monetary Policy & Inflation
On Thursday Christine Lagarde will face her toughest test yet as ECB President. The emergency rate cuts from both the Fed and Bank of England significantly increased pressure on the ECB to act. But with monetary policy edging closer to its limit, it faces a difficult task. Lagarde must ensure that the remaining space is used wisely. A comprehensive package using all the tools at the ECB’s disposal seems the most likely option.
Carney Confirms Global Central Banks Are Coordinating Policy
The world has changed since the last ECB’s Governing Council policy meeting on 28 January. Just six weeks ago Lagarde struck a relatively upbeat tone, pointing to a “moderate increase in underlying inflation” and ongoing (albeit relatively subdued) growth. Favourable financing conditions were assumed to sustain the Euro area recovery and ensure inflation’s return to target. The coronavirus wasn’t mentioned in the press statement or Q&A, with the only reference to China being the positive news from the phase one trade deal with the US.
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On Thursday Christine Lagarde will face her toughest test yet as ECB President. The emergency rate cuts from both the Fed and Bank of England significantly increased pressure on the ECB to act. But with monetary policy edging closer to its limit, it faces a difficult task. Lagarde must ensure that the remaining space is used wisely. A comprehensive package using all the tools at the ECB’s disposal seems the most likely option.
Carney Confirms Global Central Banks Are Coordinating Policy
The world has changed since the last ECB’s Governing Council policy meeting on 28 January. Just six weeks ago Lagarde struck a relatively upbeat tone, pointing to a “moderate increase in underlying inflation” and ongoing (albeit relatively subdued) growth. Favourable financing conditions were assumed to sustain the Euro area recovery and ensure inflation’s return to target. The coronavirus wasn’t mentioned in the press statement or Q&A, with the only reference to China being the positive news from the phase one trade deal with the US.
Today’s reality is markedly worse. Italy is now entirely in lockdown, schools are closed, and business is grinding to a halt. The situation elsewhere in Europe is less severe, but preventative measures are being stepped up globally and a demand shock looks set to compound the ongoing supply disruptions. Germany’s export-dependent economy will also be hit particularly hard and the Eurozone economy is unlikely to eke out much growth this year.
Lagarde’s 2 March statement on COVID-19 said the ECB will take “appropriate and targeted measures” in line with the risks. The Fed’s 3 March 50bps emergency rate cut and the Bank of England’s 11 March unscheduled 50bps cut – in addition to rate cuts at scheduled meetings by those such as the Reserve Bank of Australia and Bank of Canada – leave little doubt that the ECB will follow. While the G7 statement from 3 March talked about cooperation, the lack of co-ordination in the timing of rate cuts had pointed to a country-specific approach. But with comments from Bank of England Governor Mark Carney on Wednesday that there is a “high degree” of coordination and cooperation between global central banks, any lingering doubts over whether or not the ECB will act have gone.
ECB Likely to go For a Package of Measures Similar to September
The Euro area’s growth and inflation outlook is materially worse than when the ECB last announced a package of measures in September 2019. Not only will growth be significantly lower (and not captured in the new forecasts due for release on Thursday) but Monday’s oil price collapse will also push headline CPI further below target. Domestic demand weakness from quarantines and other preventative measures will also weigh on core inflation. While the ECB could choose to look through the direct impact of the oil shock on inflation, it cannot ignore any second-round impact on prices or on expectations.
Given the limited space for further easing and the ECB’s stance that the different tools are complementary, another multi-pronged approach seems likely. In September the bank adopted a four-pronged approach of a rate cut, resumption of asset purchases, tiering, and forward guidance (TLTROs had already been announced). Thursday’s announcement is likely to be similar but will focus more on the availability of credit, particularly to corporates.
1) Rate cut: A 10bps rate cut to -0.6% is largely priced. Bloomberg’s consensus of economists forecast is still for rates on hold but perhaps does not reflect all updated calls. Last year’s move to a tiered system for excess deposits had already opened the door for further rate cuts by reducing the cost to banks. And with credit growth remaining positive and no large-scale flight into cash, there is no evidence that the reversal rate has been hit. Tiering could also be sweetened further on Thursday by raising the amounts exempt from the negative rate.
2) Expanded Asset Purchase Programme: The ECB is now four months into its €20bn/month open-ended QE programme. The Governing Council could step up the pace of purchases or temporarily concentrate purchases in countries hardest hit, such as Italy. Diverting purchases towards corporate bonds rather than government bonds is another option to ease financing costs for business.
3) Targeted TLTROs: Providing additional liquidity could be a more powerful tool than a rate cut given the reluctance to borrow in the current environment. Tweaking the rules around TLTRO III to increase the amount of eligible borrowing (currently 30% of the loan stock) is one option. A new TLTRO aimed directly at SME financing is another.
Lagarde Will Stress the Need For Fiscal Policy to Step Up
Lagarde will very likely stress the required fiscal response at length. The recent Eurogroup statement lacked any concreate announcement, saying only that Europe’s fiscal rules allowed for flexibility in a situation of “unusual events”. Italy and Germany have already responded with some fiscal stimulus, but as a share of GDP the amounts are small given the size of the shock from COVID-19. Italy’s initial €3.6bn package is just 0.2% of GDP although the latest announcement brings this closer to a more meaningful 1.4% of GDP. Meanwhile, Germany’s stimulus measures are around just 0.1% of GDP.
Monetary policy can play a role in cushioning the shock from the COVID-19, but it is far from enough. Direct, targeted measures from governments to support businesses and households are needed – and fast.
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