April ECB meeting preview: The policy problems ahead

By Jeremy Hawkins, Senior European Economist
April 20, 2021

With no significant change in the Eurozone’s economic outlook and broadly stable sovereign bond yields since last month’s discussions market expectations are for steady interest rates and QE at Thursday’s ECB announcement. Assuming that this is indeed the case, investors are likely to look for any additional signs of splits on the Governing Council about where policy should be headed. In recent weeks, the gap between the doves and the hawks appears to have widened and while this may not be too much of an issue for now, it could become a real problem as and when the economic recovery starts to show signs of becoming sustainable.

March’s announcement that this quarter’s asset purchases under the €1.85 trillion pandemic emergency purchase programme (PEPP) would be conducted at “a significantly higher pace than during the first months of this year” reaffirmed the PEPP’s position as the main tool of QE. It also further increased the likelihood of net buying under the longstanding asset purchase programme (APP) remaining at €20 billion a month this week. Even more probable is no move on interest rates as any adjustment here simply does not seem to feature anywhere on the ECB’s radar. This means that the refi rate is all but certain to be left at 0.00 percent while the rates on the deposit and marginal facilities are held at minus 0.50 percent and 0.25 percent respectively. Lastly, forward guidance should match March’s statement which saw the ECB expecting rates to remain at their “present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2 percent within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics”.

However, the ECB’s weekly financial statements indicate the central bank has started to make greater use of the PEPP. Net purchases in the three weeks before the March meeting were averaging about €12.7 billion a week but have since been raised to an average of about €17.5 billion. That said, there is still almost €900 billion of the programme’s funds available for future transactions and the temporary step-up in purchases is only supposed to last this quarter. Even at the current buying rate the ceiling would not be reached until after March 2022, currently the earliest termination date for the PEPP. Indeed, to appease the Governing Council’s hawks, the central bank has already stressed that March’s announcement should not be seen as presaging an increase in the PEPP ceiling and noted that the fund would only be fully utilised (or adjusted again) should conditions so dictate.

Nonetheless, some members clearly think that QE has done enough already and, against the majority view and jettisoning the “whatever it takes” mantra originally adopted by former ECB President Mario Draghi, both the Austrian and Dutch central bank heads have suggested that the process of unwinding QE could start as soon as next quarter. Such conflicting policy signals threaten to undermine the very stability in financial markets that the central bank is seeking to protect.

The increase in PEPP purchases is aimed squarely at maintaining favourable financing conditions and, to this end, the results so far have been positive. The sharp climb in yields seen in February and early March has given way to a broadly flat trend and, at the time of writing, the Eurozone 10-year government bond yield is just 5 basis points above its level a month ago. Moreover, yield spreads also remain historically tight with the gap between 10-year Italian BTPs and German bunds just 102 basis points, unchanged from its reading at the time of the March meeting and well down from 130 basis points at the start of the year.

Nonetheless, to the extent that favourable financing conditions are supposed to underpin private sector borrowing, the PEPP would only seem to be providing support rather than an outright boost. Very rapid M3 growth continues to be largely a function of QE and lending to the government. In fact, some 8.6 percentage points of the 12.3 percent annual rate posted by M3 in February was attributable to credit extended to central government, currently expanding at a whopping 23.9 percent rate. Its private sector counterpart clocked in at just 5.1 percent within which household borrowing for consumption contracted at the fastest pace since January 2014. Moreover, the ECB’s newly released lending survey found a further, albeit more modest, tightening in credit standards last quarter and another marked and broad-based fall in private loan demand.

More generally, Covid restrictions have ensured weak first quarter GDP and probably a second double-dip recession. Retail sales and industrial production continued to struggle and in February both were still below their respective levels a year ago. At the same time, Brexit is negatively impacting EU-UK trade and core inflation has even fallen. Crucially however, as highlighted by Econoday’s economic consensus divergence index (ECDI), economic activity in the main has still been on the strong side of market expectations and so has not added to pressure on the ECB to ease further. That said, the ECDI recently dipped into negative surprise territory and it may be that tighter national restrictions and/or lockdowns are having more of an effect.

Looking further ahead, the scope to abandon the highly accommodative monetary policy could well be restricted by its fiscal counterpart. Compared with the likes of the U.S., the UK and Japan, the Eurozone’s fiscal response to the coronavirus has been disappointingly limited. Hence, as a simple stimulus proxy, IMF figures for last year show that the general government deficit as a percent of nominal GDP rose by 9.5 percentage points in both the U.S. and Japan and by some 11.1 percentage points in the UK. Over the same period, the Eurozone deficit expanded just 7 percentage points. Yet, already some of the traditionally more conservative governments are talking about getting the ratio back down to the 3 percent ceiling laid down in the Growth and Stability Pact (GSP). The GSP has been suspended for 2021 but talks are underway about what should happen in 2022 and a net borrowing target anywhere near the 3 percent mark would imply a significant fiscal tightening. Little wonder then that many Governing Council members are regularly emphasising the need to avoid what could be a very damaging premature withdrawal of fiscal support.

As it is, the EU Commission’s flagship €750 billion Next Generation EU (NGEU) recovery programme is currently bogged down by a fresh challenge in the German High Court and the absence of ratification by several member governments. The risk of a delayed implementation is rising and a significant postponement – the fund is scheduled to begin tapping the capital markets to finance its disbursements in July – would hit the peripheral Eurozone bond markets and cause a deterioration in Eurozone financing conditions.

Irrespective of policy, Covid developments will inevitably continue to dictate the economic outlook over at least the near-term. Since the March meeting, high, and in many cases rising, infections have forced a widespread tightening of restrictions. In early April, France extended its soft lockdown to all the mainland for at least four weeks while the German government is seeking to strengthen and extend current lockdown measures until the end of May or mid-June. Italy has a partial lockdown until at least the end of the month and an evening/overnight curfew. Consequently, the vaccine rollout remains key to investor sentiment. At currently about 25 per hundred, injections have been woefully short of the likes of the UK (63) and the U.S. (62) and, despite some acceleration in the rate recently, the rollout now looks likely to be restrained by new safety scares over both the AstraZeneca and Johnson & Johnson vaccines. The ECB is far from happy with the sluggish vaccine programme as anything that slows the delivery timetable would only be bad news for economic recovery.

So, in sum, the good news for the ECB is that the Eurozone economy last quarter could have performed a lot worse than it actually did. And this combined with no further significant increase in longer-term borrowing costs should leave the central bank comfortable enough with its existing policy stance. However, what to do next with policy is a much thornier issue and it will be a real test of President Lagarde’s diplomacy skills to secure a consensus from a Governing Council that is starting to pull in very different directions.