July ECB meeting preview: Time to assess the damage

The ECB’s policy announcement this week is expected to be a relatively low-key affair. Having expanded its QE programme just last month via a larger than anticipated €600 billion increase in its pandemic emergency purchase programme (PEPP), the central bank will want to wait and see how its latest measures are received. So, the asset purchase programme (APP) should be held at an open-ended €20 billion/month alongside both the €120 billion temporary QE envelope due to end in December and the wholly separate €1.35 trillion PEPP which will run at least through June 2021. As of end-June, cumulative net purchases of debt securities under the PEPP stood at €355.0 billion.

PSPP: Public sector purchase programme CBPP3: Third covered bond purchase programme
ABSPP: Asset-backed securities purchase programme CSPP: Corporate sector purchase programme

At least one national central bank governor has suggested that the full PEPP might not be required as the economy begins to stabilise and the need for extraordinary support diminishes. However, this assumes that any second wave of the virus is contained and has only limited effects. In any event, the PEPP has so far successfully helped to keep longer-term borrowing costs low while at the same time narrowing yield spreads between Germany and the Eurozone peripherals. Moreover, the monetary authority must feel under pressure to do all that it can to underpin recovery prospects as the politicians continue to squabble over size, structure and allocation of the post-Covid Recovery and Resilience Fund (RRF). Differences here will be addressed at an EU leaders’ summit at the end of this week but should there be no resolution then, hopes for a coordinated fiscal response would be badly hit.

Meantime, while always a possibility, there would also seem to be no appetite for any further cuts in key interest rates implying that the deposit rate will remain pegged at minus 0.50 percent, the main refi rate at 0.00 percent and the rate on the marginal lending facility at 0.25 percent.

In fact, the ECB appears to have all but given up on interest changes as a means of stimulating economic growth (it has also seemingly ruled out yield curve targeting). Late last month, chief economist Philip Lane pointed out that longer-term sovereign yields have become virtually unresponsive to short-term interest rate cuts making asset purchases a much more effective tool to deal with the current crisis. To this end, the launch of the PEPP on 18th March and the subsequent announcement of its increase on 4th June were instrumental in driving yields lower. Indeed, combined with the expansion of the ECB’s original asset purchase programme, the PEPP is officially expected to reduce 10-year sovereign bond rates by almost 45 basis points below where they might otherwise have been.

Under its central case scenario, the ECB’s June economic forecasts showed Eurozone real GDP not regaining its pre-Covid-19 level until the second quarter of 2022. In other words, the central bank expected only a measured recovery from the virus-driven slump in business and consumer activity endured during the first half of the year. Some ongoing containment measures and an only gradual waning of high uncertainty are seen constraining growth until a medical solution becomes available, which is assumed to happen by mid-2021. This argues in favour of policy retaining an easing bias going forward.

In practice, there have been some early tentative signs that spending could rebound rather faster than previously thought although even then, a surprisingly sharp bounce in May retail sales was only from a very weak level and might simply reflect a temporary release of pent-up demand caused by the lockdown. Industrial production looks to be picking up somewhat more slowly. Meantime, the region’s headline inflation rate is dangerously close to zero and the narrow core rate, which remains soft but relatively stable, is about to be undermined by a cut in German VAT. The German move is supposed to be reversed at the beginning of 2021 but, in the interim, it could still weaken inflation expectations which would further complicate the ECB’s price stability aspirations.

For now, the ECB will want to take time to assess how effective its latest batch of stimulus measures has been. However, no change in policy on Thursday should not be seen as the end of the easing process. There is almost certainly a lot of bad economic news still in the pipeline and, particularly should the RRF fail to deliver, the central bank’s balance sheet could yet end the year significantly larger than current policy plans might suggest.