ECB actions fall short in design and delivery (only in English)
- ECB announces easier and cheaper access to long term financing for banks
- ‘Additional envelope’ of €120bn temporarily added to Asset purchase Programme
- Discounted rate cut fails to materialise…
- …leaving markets wondering if ECB is unable or unwilling to do more
- Rationale for aggressive action clear as outlook worsens
- ECB projections envisage ‘mild’ Coronavirus scenario of flat Euro area GDP growth and severe scenario of significantly negative growth in 2020
The outcome of yesterday’s ECB meeting is not entirely surprising but was still quite disappointing and contributed to a further worsening of sentiment in financial markets. At a technical level, the policy measures announced by the ECB go some way to alleviating real and potential strains in bank lending in the Euro area. However, in two key respects of delivery and design they fall significantly short of what is required in current circumstances.
As the ECB notes in its press statement the spread of the Coronavirus represents a major shock to growth prospects. A key element in this regard is hugely increased uncertainty and an associated sharp deterioration in sentiment in financial markets and (anecdotally at least) in the broader economy. In such circumstances, a central contribution of policy makers is to deliver ‘shock and awe’ in terms of the strength and range of the policy response. The ECB actions fell significantly short in this respect for reasons we discuss below.
First of all, markets had come to expect a large and wide ranging policy package from the ECB. Recent intermeeting ‘emergency’ rate cuts by the Federal Reserve and the Bank of England emphasised the seriousness of the current situation globally and illustrated the reaction function of major Central Banks. While the ECB’s deposit rate is significantly negative at -0.5% and many (ourselves included) have queried the merits of further reductions, the decision by the ECB last September to introduce a tiered deposit scheme seemed designed to open up scope for further cuts.
According to ECB president Lagarde the absence of a rate cut does not signal that the ECB has reached its effective Lower Bound but markets may draw exactly that conclusion and worry that the scope for further monetary policy support in the Euro area is very limited.
In a similar vein, the announcement of ‘a temporary envelope of additional net asset purchases of €120 billion until the end of the year’ was very short of detail on how this might operate and, in particular, how looming ECB imposed limits on its purchases of certain countries bonds might be overcome. It is understandable that the ECB might wish to keep some flexibility in regard to the use of this extra bond purchasing power but nervous markets want some reassurance that this firepower can be deployed.
It should be acknowledged that the ECB announced a couple of amendments to its refinancing operations for commercial banks that will support financing conditions in the Euro area. Additional temporary Long Term Refinancing Operations will provide near term liquidity support but much more importantly, the ECB introduced more favourable financing terms that could allow banks borrow at rates as low as -0.75% in the three year Targeted Long Term Refinancing Operations scheduled to start between June 2020 and June 2021. It also increased the amount of funding that banks can access at these operations. However, the scale of boost this may give the real economy may be limited because of increased caution on the part of both borrowers and lenders.
Draghi has left the building
A second consideration in terms of the ECB’s actions is that the delivery of the decisions by ECB president Christine Lagarde did little to instil confidence that the ECB can and will act aggressively to support the Euro area economy. In marked contrast to the ‘whatever it takes’ commitment uttered by her predecessor Mario Draghi, yesterday’s messaging suggested that the ECB envisages it will play an altogether more limited role in responding to the current crisis.
Ms Lagarde may be entirely correct to argue that the nature of the current crisis means the policy response should be ‘fiscal, first and foremost’. However, the inference that the ECB will play a lesser role will feed the worries now unnerving financial markets.
In response to questions, Ms Lagarde’s repeated references to ‘making use of all the flexibility’ in the Asset Purchase Programme to avoid running into ECB imposed limits to its capacity to fully utilise a proposed €120 billion increase in that programme may hint at someone still coming to terms with what are very technical and relatively new monetary policy tools.
More disturbingly, her undiplomatic response to one question on increasing financial market strains that ‘we are not here to close spreads’ suggested gaps in her understanding of monetary transmission channels in the single currency area and associated travails during the recent Eurozone crisis and prompted a threatening surge in Italian bond yields and a marked widening in spreads across other Euro area Government bonds.
ECB fully appreciates economic threat
It should be emphasised that the underwhelming nature of yesterday’s ECB actions does not stem from an underestimate of the scale of threat now facing the Euro area economy. While today’s ECB projections entail only a modest downgrade to the outlook for GDP growth in 2020, the cut-off date for their preparation of 18th February means they have been completely overtaken by events.
However, the accompanying documents contain an exercise modelling two scenarios for the economic impact of the Covid 19 pandemic. The milder of the two entails a worsen of the outlook for GDP growth in 2020 of between 0.6%and 0.8%. The more severe scenario envisages the same initial health related fallout but adds greater negative financial effects such as wider credit spreads, weaker equity markets and house prices as well as a 20% drop in oil prices and envisages a worsening of the GDP outlook of between 0.8% and 1,4%.
So, in broad terms, the ECB envisages that the Coronavirus outbreak will cause GDP to flatline in a mild scenario and could cause GDP to drop by a half per cent or more in a more severe scenario.
Permission to panic?
Significantly, the gap between the two scenarios does not reflect any greater direct dislocation of the economy from the pandemic. Instead it highlights the importance of financial sentiment. This underscores how important it is that Central Banks appear to be in control of the areas within their mandate and a little beyond in current circumstances-even if the ECB is right to call for more determined action in relation to fiscal policy and health related measures.
Unfortunately, the design and delivery of yesterday’s ECB actions may give markets one more reason to worry in coming months. At very least, it will sustain volatility but it could also focus greater attention on ‘safe assets’ and the scope for spread widening.
In contrast to the experience of most of the past decade, when the ECB was seen offset major shortcomings in relation to fiscal policy and other policy areas, there is a sense that the ECB may be less able and/or willing to do ‘whatever it takes’.