January ECB meeting preview: New year, same problems

By Jeremy Hawkins, Senior European Economist
January 19, 2021

Not surprisingly in the wake of the additional monetary boost provided at the December meeting, market expectations for Thursday’s ECB announcement are suitably low. If anything, last months’ easing package was a little more generous than anticipated which makes another dip into the central bank’s tool box this week all the less likely this month.

Consequently, monthly net asset purchases under the longstanding asset purchase programme (APP) are seen steady at €20 billion with acquisitions continuing until just before official interest rates are hiked. (Note that the previous temporary €120 billion emergency APP envelope expired at the end of 2020). The pandemic emergency purchase programme (PEPP) should similarly remain at the €1.85 trillion level to which it was expanded last time and retain a termination date no sooner than March 2022. At the same time, key interest rates will be kept on hold leaving the refi rate at 0.00 percent and the rates on the deposit and marginal lending facilities at minus 0.50 percent and 0.25 percent respectively. Lastly, forward guidance will probably reaffirm December’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.”

As reaffirmed last month, the PEPP and targeted longer-term refinancing operations (TLTROs) are currently regarded as the most effective policy instruments to combat the fallout from the virus. Regarding the former, there is unlikely to be any pressure for a further increase for some time. Cumulative net purchases at the end of 2020 stood at only about €757 billion or around 40 percent of the overall fund meaning that nearly €1.1 trillion remained available for future buying. In fact, purchases have averaged only €63 billion a month since July and at this rate, the PEPP would still have roughly €330 billion left for disbursement at year-end. In practice however, the programme is much more flexible than the APP and can be used more or less according to market conditions. This makes it a potentially highly important backstop. Meantime, the first of December’s three additional TLTROs, which provide cheap borrowing for banks on the condition that they on-lend the funds to non-financial corporations and households, will be conducted between June and December. Alongside these, the newly introduced quarterly pandemic emergency longer-term refinancing operations (PELTROs) will launch in late March.

To date, the PEPP has been mainly directed at the Eurozone’s southern bloc. As a share of 2019 national GDP, purchases of Greek, Portuguese, Cypriot, Italian and Spanish assets have quite easily outpaced those of the other member states. In part, this reflects the particularly negative impact that Covid-19 has had on these economies but also the ECB’s determination to keep financial markets operating as smoothly as possible. To this end, the programme would seem to have contributed significantly towards maintaining historically tight sovereign yield spreads, a key input into central bank’s assessment of financial stress. Eurozone yields have risen so far in 2021 but, despite some fresh political wobbles in Italy, at the time of writing the 10-year Italian BTP-German bund spread is essentially unchanged on the month and nearly 50 basis points below where it was a year ago.

Just last week ECB President Lagarde insisted that, despite the surge in infections during the second wave of the virus, the central bank’s December economic projections remained broadly on track. However, the signs are that household demand was badly affected by a series of renewed national lockdowns in November and but for a surprisingly robust performance by Germany, Eurozone retail sales would have fallen by even more than the reported monthly 6.1 percent. As it is, December needs to see sales jump more than 7 percent or the retail sector will subtract from fourth quarter economic growth. Moreover, even in Germany new cases are still well above the government’s daily target threshold of 50 per 100,000 and the current lockdown due to be lifted at the end of this month seems certain to be extended again. This could undermine one of the region’s few areas of relative consumer strength.

In the main, output appears to have been much less impacted (although November’s jump in industrial production was misleadingly firm). The PMI surveys pointed to only a minor contraction in overall private sector business activity at year-end and a probable fall in fourth quarter GDP now looks likely to be quite limited. That said, coronavirus restrictions obviously make for downside risk. Meantime, inflation remains a major thorn in the side of policymakers and the annual narrow core rate was still at a record low of just 0.2 percent in December. Positive base effects from the oil market and this month’s reversal of last July’s cut in German VAT will help to lift the headline rate over the near-term but without a pick-up in demand, even rising costs caused by stretched supply chains will struggle to provide much of a boost to underlying consumer prices.

Infections during the second wave of the virus were climbing exponentially in many Eurozone countries in late October and early November. A combination of lockdowns and more aggressive restrictions seems to have turned the tide but the latest readings are still higher than the peaks seen during the first wave and in some states case rates are already rising again. As such, containment measures are unlikely to be eased meaningfully for some time, ensuring that both demand and supply remain below potential during the first quarter if not longer. Consequently, the vaccine rollout remains vital to how the economy shapes up in 2021 and, so far, deliveries have been running behind target.

So, the ECB faces much the same suite of problems now as it did in December. The Eurozone economy could be entering a second double-dip recession, inflation is still way too low and the only sustainable way out of the pandemic remains firmly in the hands of vaccines that have only just started to be distributed. Not helping matters, the central bank’s newly released lending survey, which was an important factor in the December ease, found a further tightening of credit standards last quarter. More positively, the central bank will be relieved that EU leaders have signed off on the €1.8 trillion long-term budget and Covid-19 recovery package and that agreement was finally reached on a post-Brexit trade deal. Nonetheless, while the ECB will want time to assess the effectiveness of last month’s policy recalibration, for now the balance of risks remains in favour of additional easing further out – especially should fiscal support be withdrawn prematurely.