When Christine Lagarde announces the European Central Bank’s latest policy decision on Thursday, she will have a simple message for eurozone governments and banks: do not worry about rising debt levels, borrowing costs will stay low for a very long time.
Ms Lagarde and other ECB policymakers have signalled in recent weeks that they are highly likely to increase the central bank’s stimulus measures in an attempt to ease the continuing economic damage caused by the coronavirus pandemic.
Measures are expected to include an expansion of the ECB’s main crisis-fighting tools by buying more bonds for a longer period, while funding banks at deeply negative interest rates as long as they keep the credit flowing.
Rising debt is vital to support the pandemic-stricken economy, Ms Lagarde is expected to emphasise.
Some investors believe the expanded stimulus package means the ECB has adopted an informal strategy of “yield curve control” — aiming to keep sovereign bond yields at a certain level to cap borrowing costs until the economy rebounds and inflation rises to its target of close to, but below, 2 per cent.
Ms Lagarde has stopped short of openly committing to such a strategy, as the Bank of Japan and Reserve Bank of Australia have done, but she promised last month that “financing conditions will remain exceptionally favourable for as long as needed”.
That leaves ECB-watchers with four main areas to look out for.
As the virus took hold across Europe this spring the ECB launched a fresh effort at quantitative easing, the Pandemic Emergency Purchase Programme (PEPP), with the aim of buying up to €1.35tn of bonds.
It is scheduled to run until June but, confronted with recent weeks’ fresh wave of coronavirus infections and restrictions, the ECB is likely to expand the size and timeframe.
There is still €600bn of the original left to spend; most economists expect the ECB will add at least another €500bn and extend PEPP to the end of 2021. Many think it could go further, extending to June 2022.
That would be enough for the ECB to buy 70 per cent of all bonds issued by eurozone governments next year, and 150 per cent of net issuance after redemptions, according to Frederik Ducrozet, strategist at Pictet Wealth Management.
“The ECB don’t want to say it out loud but they are effectively in yield and spread control,” said Richard Barwell, head of macro research at BNP Paribas Asset Management. “They are basically out of ammunition and relying on good luck and good fiscal policy when it comes to reflating demand even if they can keep pumping up asset prices.”
A bigger question is how the ECB will decide when the pandemic crisis is over. Isabel Schnabel, an ECB board member, said this month that “the economic crisis will take longer than the health crisis” — indicating the ECB is likely to continue buying bonds long after enough people are vaccinated to defeat the pandemic.
Bigger boost for banks
Lending money to banks at ultra-low rates to encourage them to keep credit flowing is the ECB’s other main crisis-response tool. Its targeted longer-term refinancing operations (TLTRO) have lent almost €1.5tn to banks at rates as low as minus 1 per cent if they maintain lending levels.
The programme is due to expire in March and the ECB has indicated it is likely to be extended. It is less clear whether the rate will be lowered further into negative territory. Krishna Guha, vice-chairman at Evercore ISI, said the ECB could introduce “an add-on hyper-concessional rate” for banks that increase lending to small businesses.
Few economists expect the ECB to cut its headline deposit rate from minus 0.5 per cent. But doubts exist over whether it will raise the exemption for lenders on the negative interest they pay on deposits at the central bank. This exemption is set at six times a bank’s minimum reserves, but ABN Amro’s Nick Kounis predicted it would rise to eight times after banks’ excess deposits surged from €1.8tn to €3.3tn.
Given that coronavirus vaccines are close to being approved and delivered across Europe, the ECB could be expected to adopt a sunnier outlook in its latest economic forecasts.
But the likelihood of a downturn in the fourth quarter means most economists expect it to lower its growth outlook for next year, even if this is offset with a more upbeat outlook for 2022 and 2023.
A vital question will be whether the ECB cuts its inflation forecast and how far below target it expects price growth will be by 2023.
In recent weeks the euro has climbed above $1.21, its highest level since 2018. While this mostly reflects a weaker US dollar, it is a concern for the ECB as a stronger euro puts downward pressure on inflation by lowering import prices.
A stronger euro “negates almost all of the reflationary benefits from national and expected joint fiscal measures in response to the pandemic this year”, according to Lena Komileva, chief economist at G+ Economics.
Ms Lagarde has said the ECB is monitoring the exchange rate; she could express further concern about the economic consequences of it remaining persistently high.