At today’s meeting, the European Central Bank’s (ECB) Governing Council (GC) left all major policy levers unchanged but pre-announced changes that will be rolled out at the next meeting. ECB President Christine Lagarde repeatedly noted that the “whole” Governing Council was “in full agreement” that a recalibration of the policy package was going to be necessary in December when the new macro projections will be available. Lagarde did not pre-commit to any particular policy changes in December, however, and it stands to reason that some are more palatable to the GC than others.
Lagarde noted that inflation is going to stay negative into early 2021, affected by a number of shocks, but she stressed in this context the distinction between negative inflation due to known temporary factors and broader deflation. While it seems to us that the much larger issue is the shortfall of core inflation relative to expectations (rather than headline inflation), we would agree that inflation volatility certainly complicates the picture over the near term. Over the longer term, however, the ongoing second pandemic wave is likely to lead to continued downside surprises for the trajectories of output and inflation, highlighting the need for new, lower forecasts and additional stimulus.
While Lagarde asserted that no policy changes had been discussed today, we believe it would be straightforward to enact a more accommodative stance even before December without requiring an explicit decision, simply by increasing discretionary purchases under the Pandemic Emergency Purchase Programme (PEPP). In thinking about the December meeting, the range of potential policy changes is quite wide and given today’s forceful delivery includes measures that might appear less mainstream. In addition to further easing and/or extending the Targeted Longer-Term Refinancing Operations (TLTRO) conditions again, we could also imagine the GC reconsidering collateral rules. By December, the ECB will also have more than one year of experience with the tiered reserve requirement system. An increase of the coefficient that determines the exemption from negative deposit rates could be part of the package in order to increase banks’ profitability if the second wave of lockdowns would be deemed, by then, to have a particularly negative impact on banks. The ECB could also go in a different direction and use the flexibility under the PEPP to buy longer maturities in order to take out more duration from the market.
Today’s meeting was striking in how it conveyed certainty of policy action on several fronts in December. The risk is that perhaps Lagarde promised more today than the GC is willing to deliver then, which is why we think Lagarde shied away from being too specific. Today is a clear tailwind for bonds as an explicit expansion and extension of the PEPP, the current cornerstone of ECB policy, is the most likely candidate for a boost. This will become even more obvious if, as we expect, the ECB pushes the current absorption rate of the PEPP higher in the interim to signal a more accommodative stance, thereby using up more of the remaining envelope.
We noted that toward the end of the press conference Lagarde juxtaposed the “unique” unanimity today (with respect to the recalibration need in December) with the fact that policy action on any specific instrument only required broad agreement among the GC and not unanimity. We interpret this as putting more contentious suggestions, such as an interest rate cut, on the table, as this would clearly see some opponents emerge, especially if underlying inflation trends were to improve by then. To some extent, the course of action will also depend on where the effective euro exchange rate stands by early December. That said, it will be interesting to see what other members of the GC, including ECB Chief Economist Philip Lane, think of the interaction between the size of the balance sheet, the exchange rate and the policy rate—as Lane noted quite recently that the window for interest rate cuts may have already closed.