December ECB meeting preview: Easing into 2021
By Jeremy Hawkins, Senior European Economist
December 8, 2020
Financial markets will be hugely surprised and no less disappointed should Thursday’s ECB announcement fail to deliver another round of easing. Speculation was given a massive lift in late October when that month’s meeting emphasised agreement on the need for a wide-ranging recalibration of the central bank’s monetary policy tools – which is about as clear as the ECB ever gets when it comes to flagging a near-term shift in its stance. Official comments since then, not least by President Lagarde, have simply left investors all the more convinced that new measures are just around the corner.
Exactly what shape the recalibrated policy mix will take remains to be seen but it could include anything from changes to size, duration and intensity. Rather more obvious is the apparent lack of enthusiasm for another cut in official interest rates. It may be that the lower bound has not yet been reached but with the entire Eurozone yield curve already negative out to 30 years, it is far from clear what any fresh reduction would achieve in the first place. This means that the refi rate should be held at 0.00 percent while the rates on the deposit and marginal lending facilities remain at minus 0.50 percent and 0.25 percent respectively.
Instead, the focus is likely to be on QE and targeted longer-term refinancing operations (TLTROs); both instruments having been seen as highly effective to date. With regard to QE, net purchases under the longstanding asset purchase programme (APP) are currently scheduled to continue running at €20 billion/month until just before interest rates are hiked. However, the €120 billion temporary QE envelope introduced as part of the APP in March is due to expire at year-end, implying a reduction in net asset purchases of around €13 billion a month without any offsetting action. Normal APP purchases could be raised to fill the gap but any such call would probably meet with resistance from the Governing Council’s hawks and could run up against supply-side constraints caused by the capital key which puts a limit on national purchases.
A more likely route to raising the QE bar is via the pandemic emergency purchase programme (PEPP). This has the benefit of being significantly more flexible than the APP and appears to have become the QE tool of choice since its launch in March. The PEPP currently stands at €1.35 trillion, of which only €0.70 billion had been used as of November 27. Indeed, at October’s pace of purchases, the ceiling would not be hit until around September next year so there would be no immediate pressure to expand the programme even should it be used to fill the gap left by the loss of the temporary QE envelope. However, an outright increase would bolster its potential as a backstop should conditions require and would send a clear message to financial markets that the ECB is determined to keep policy highly accommodative for as long as necessary. Alongside a boost to the PEPP of probably at least €500 billion, its duration is likely to be extended through year-end 2021, if not into the middle of 2022.
In addition, any easing package could well see an expansion of the TLTRO scheme. Sovereign bond spreads across the region remain tight but the central bank is clearly concerned about the risk of a reversal of accommodative financing conditions. To this end, with borrowing costs for banks as low as 50 basis points below the minus 50 basis point deposit rate, the current third series (TLTRO III) has been a very attractive source of funding for banks and a key support for lending to businesses and households. The ECB’s October bank lending survey found that, having spiked during the first wave of Covid-19 in the second quarter, standards continued to tighten ominously in the quarter just ended. Moreover, banks also anticipate a further tightening this quarter for both enterprises and house purchase. This makes a targeted approach to any new package all the more appealing and probably means that the TLTRO programme will be extended – possibly by another year to the middle of 2022.
Meantime, the Eurozone real economy, which had already slowed sharply before the second wave of the virus really got going, has been hit hard by new lockdowns across much of the region. Many were introduced in late October/early November and will be only partially relaxed by year-end. Indeed, just last week, Germany announced that its current nationwide restrictions would be extended until at least January 10. Although the latest measures are generally not as aggressive as those in April/May, the PMI surveys warn that GDP most likely contracted in November and will struggle to keep its head above water over the fourth quarter as a whole. With core inflation still at a record low of 0.2 percent last month, overall economic fundamentals have deteriorated markedly since October’s deliberations.
Not helping matters is the weakness of the U.S. dollar. Alongside most of the other major currencies, the euro has appreciated significantly against the greenback since late March and gains in recent weeks have been especially pronounced. Indeed, last Tuesday saw the unit move above €1.20 for the first time since 2018. Historically, current levels are not particularly high – the average rate over the last decade is €1.213 – but by depressing import prices (down 3.3 percent on the year in September) the latest bout of euro appreciation has come at a bad time for a central bank struggling to get anywhere close to its near-2 percent inflation target. At the central bank’s September meeting President Lagarde made plain that the Governing Council was worried by the deflationary effects of recent exchange rate moves and at that time the Euro was only around $1.18 compared with about $1.21 now. The ECB does not have a target for the euro but the impact of the currency’s rise on HICP inflation will contribute towards Thursday’s ease and efforts by Lagarde to jawbone the unit lower are only to be expected. In fact, should euro strength not feature at the press conference, the currency could climb still higher.
The ECB will at least face some better news on Covid-19. Infection rates soared right across Europe in the first half of the current quarter but the subsequent tightening of restrictions has prompted a significant decline since mid-November. At least as important, the first fully tested vaccine is also now being rolled out. Both developments bode well for a return to sustainable economic growth next year and so should help to determine the duration of the monetary instruments employed over coming months.
The law of diminishing returns points to only a limited impact on Eurozone economic activity from whatever the ECB opts to do on Thursday. However, the economy needs help and, for now at least, fiscal policy is not playing ball. The EU Commission’s much-touted €672.5 billion Recovery and Resilience Facility (RRF), part of the EU Budget and regarded by the ECB as vital to a significant and sustained pick-up in growth in 2021, continues to be blocked by Hungary and Poland with no obvious path out of the current impasse. To make matters worse, time is very nearly up for the EU and the UK to agree a post-Brexit trade deal and failure to do so would deal the economy a sizeable hit next year and beyond. Seen in this light, pressure on the central bank to act is even greater than the economic data alone might suggest.