September ECB meeting preview: Pressure to prime the PEPP

September 8, 2020

On the whole, market expectations are for no change in policy at Thursday’s ECB announcement. This would mean net purchases under the asset purchase programme (APP) remaining at an open-ended €20 billion/month, supplemented by the €120 billion temporary QE envelope due to end in December. More significantly given the current focus of policy, it would also see the wholly separate pandemic emergency purchase programme (PEPP) scheduled to run through at least June 2021 being held at €1.35 trillion. At the same time, there is a strong consensus for no move on key interest rates which increasingly appear to have bottomed (refi 0.00 percent, deposit minus 0.50 percent and marginal lending 0.25 percent).

Having been launched in March, cumulative net purchases under the PEPP amounted to more than €440 billion at the end of July and have become the mainstay of the ECB’s QE efforts. Buying has been primarily directed at public sector securities (87 percent) although both commercial paper (8 percent) and corporate bonds (4 percent) have benefitted too. Unlike the APP which has a fixed monthly target, the PEPP is flexible and this was reflected in a relatively low purchase figure for July when the central bank thought financial conditions were improving. The fund’s €600 billion expansion in June was particularly well received by investors and the ECB must be happy with the slide in longer dated yields that has followed.

The PEPP has also helped to narrow bond spreads across the region, a key test of financial stability as far as the ECB is concerned. However, to some extent this has been at the expense of the so-called capital key that is supposed to determine a country’s share of the asset purchases. This is particularly of true of Italy which, by the end of July, had clearly benefitted disproportionately by providing almost 20 percent of overall assets purchased.

However, if the ECB is happy with the way in which the PEPP has helped to smooth the workings of the financial markets during the pandemic, it must still be very concerned by the state of the Eurozone economy. The recovery in consumer demand has started to stutter and growth of output continues to lag. Indeed, industrial production in June was still more than 11 percent short of February’s level and August’s PMI composite output index signalled a sharp deceleration in private sector business activity. To make matters worse, inflation has fallen sharply too. The flash August data showed the headline rate sliding below zero for the first time since May 2016 and, more significantly, the narrow core measure dropping to a new record low of just 0.4 percent. Both gauges have been biased down by July’s cut in German VAT and delayed seasonal sales, but the mid-quarter readings were well short of market expectations. September is likely to see a partial rebound and the German VAT reduction is currently scheduled to be reversed at the start of 2021. Even so, it would seem that Covid-19 is having a dampening effect upon prices and with the euro having appreciated more than 10 percent against the dollar from its March lows, the near-2 percent HICP target is looking more distant than ever. The ECB’s in-depth strategic review of monetary policy currently underway could not have come at a better time.

There have also been some worrying signs in the M3 data. Annual M3 growth has picked up very sharply since the outbreak of the coronavirus and in July stood as high as 10.2 percent. However, the broad money aggregate has been boosted by a surge in government borrowing used to finance a swathe of emergency rescue packages and headline strength has masked some softening in the key private sector lending counterpart. This is consistent with the central bank’s second quarter lending survey which found a sizeable jump in corporate distress borrowing offset by a marked decline in borrowing for investment. The same survey also noted generally weak household loan demand including a record low in the non-mortgage sector.

In any event, it will be the coronavirus that has the biggest say in determining the outlook for the Eurozone economy and, hence, ECB policy. And recent developments here have been ominous with new cases rising across much of the region, notably in France and Spain where the 7-day rates have hit new peaks. This has already prompted a series of localised lockdowns and the partial reintroduction of restrictions on business activities and travel, both sets of measures posing a potential threat to the economic recovery and sparking some fresh speculation about further monetary easing.

According to ECB board member Isabel Schnabel, disruptions related to the latest jump in infections were already factored into the central bank’s June baseline forecasts implying that there is currently no need to add to the existing stimulus. If so, this should be confirmed in the central bank’s updated economic forecasts also due for release on Thursday. However, should the growth and/or inflation projections be marked down materially, they could well provide the fundamental ammunition necessary to justify another ease, most probably via another increase in the PEPP. Otherwise it will be interesting to hear what President Lagarde has to say about the exchange rate. The ECB typically tries to distance itself from the swings in the currency markets when determining its stance. However, following the euro’s recent sharp gains Chief Economist Philip Lane last week pointed out that the exchange rate “does matter” to monetary policy. Should the central bank chief reiterate this view, there could be a significant negative impact on the single currency.