After all the fireworks of the European Commission’s recovery package, Christine Lagarde still finds the burden of supporting the European economy falling on her institution’s shoulders.
Analysts and financial markets are expecting Lagarde’s European Central Bank on Thursday to unleash another barrage of economic stimulus to strengthen the sense that the worst of the pandemic’s financial impact is over — and to send a strong signal that it really doesn’t care about the German Constitutional Court’s effort to muscle in on monetary policymaking.
She’ll need to act. The Commission’s recovery fund is probably a year away from having any tangible impact, leaving the ECB and, to the extent they’re able, national governments as the only players in position to catch an economy still in freefall.
Any action the central bank takes Thursday will also have an extra psychological impact as it will be seen as a rebuke to the Karlsruhe court’s landmark ruling last month.
“The severe economic fallout is having a deflationary effect, which means the ECB is likely to stay in a crisis-fighting mode for some time to come,” Bert Colijn, senior eurozone economist with ING, said in a preview of the meeting.
The ECB is likely to say in its new forecasts that the euro-area economy will shrink by at least 8 percent this year because of the COVID-19 pandemic. Lagarde herself said as much last week in admitting that the mildest of the three scenarios the ECB presented when it last got out its crystal ball, which projected a decline of “only” 5 percent in gross domestic product, “is probably outdated.”
“We’ll have a better sense in a few days as we publish our numbers in early June, but it’s likely we will be in between the medium and severe scenarios,” Lagarde said in an online Q&A.
While the bank’s key interest rates will likely remain unchanged, a broad consensus expects the bank to raise the volume of its €750 billion Pandemic Emergency Purchase Program (PEPP) by another €500 billion — if only because the program is otherwise set to run out of ammunition within a few months.
Pantheon Macroeconomics’ Claus Vistesen noted that the ECB has boosted other bond-buying programs and its usual lending to banks by €630 billion so far since March alone.
The bank is due to announce how exactly it has spent that money on Tuesday afternoon. Most likely, it will reflect disproportionately heavy buying of government debt from the eurozone’s southern rim, in an effort to stop any speculation that the pandemic will finally force out the economically weaker members of the currency bloc.
The record of the ECB’s last Governing Council meeting, released last week, gave a sense of awareness that a central bank widely regarded as slow to react to the last crisis couldn’t afford to be behind the curve this time around.
“It was underlined that past experience showed that a loss of confidence in financial markets had to be avoided and preemptive action was preferable,” the minutes said.
The ECB can pat itself on the back at pushing liquidity out to the economy through the banking system quickly this time. Companies have drawn down over €180 billion in debt since March, greatly reducing short-term default risks.
The Frankfurt institution still has numerous ways to prop up the economy. ING credit strategist Timothy Rahill argued it will most likely follow the U.S. Federal Reserve in expanding its asset purchases to include the bonds of “fallen angels” — issuers who have just lost their investment grade credit rating.
The ECB already has relaxed its collateral eligibility requirements for recently downgraded bonds.
However, Rahill argued that the bank is likely to hold off buying other high-yield — meaning riskier — debt or the senior bonds of eurozone banks. The latter, he noted, would be a conflict of interest given the ECB’s role as an industry supervisor.
Pictet Wealth Management’s Frederik Ducrozet said the ECB also could increase the amount of excess reserves it allows banks to hold without penalty, to eight times their minimum reserve requirement from the current six. Such a move could save cash-strapped banks some €1.4 billion a year.
‘The middle finger’
The judges at the German Constitutional Court last month threatened to stop the Deutsche Bundesbank participating in an older bond-buying program, which would set a precedent for the ECB’s current defense against pandemic effects.
Action now would be another assertion of the independence and power of European institutions over national ones, coming only a week after the Commission proposed a substantial expansion of joint borrowing to paper over southern Europe’s fiscal cracks.
The euro rose over 2 cents against the dollar last week, while sovereign yield spreads — how much more Italy and other governments pay to borrow compared to Germany — tightened to their lowest in nearly two months in anticipation of greater transfers between EU countries.
“The sudden Franco-German debt unity may have increased the ECB’s confidence in ‘being allowed’ to give a middle finger to the Karlsruhe ruling,” Nordea analysts headed by Andreas Steno Larsen said in a note to clients. But they said Lagarde, who has pressed governments to boost spending for the sake of the economy, may also hold back to ensure political leaders don’t rely solely on the central bank.
The Nordic bank analysts said, “Lagarde may be tempted to keep up the pressure on politicians to get the debt deal done before the ECB ramps up asset purchases once more.”
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