ECB Review - July 2020: Questions On PEPP Remain Unanswered

MNI Point of View:

As one of the most consensual monetary policy meetings for some time, yesterday's GC decision and press conference played out largely as expected. The ECB made no adjustment to its main policy tools, reaffirmed its commitment to adjust all policy instruments as necessary, and maintained the core message on the economic trajectory. President Lagarde acknowledged the apparent bottoming observed in economic data and the strength of the rebound. However, as we expected, the optimism was muted with continued reference to persistently weak demand over the medium term, 'heightened uncertainty' and downside risks to the ECB's central forecast.

Some commentators had wondered beforehand whether Lagarde would echo recent comments made by Lane, Schnabel and Knot on the possibility of the current PEPP envelope not being fully utilised. While this possibility was acknowledged in the event that economic activity surprises strongly higher, Lagarde stressed that the ECB did not view this as likely and that the PEPP had been carefully calibrated to satisfy its dual function (preventing financial fragmentation and countering the shift lower in the inflation trajectory caused by the coronavirus crisis) and that the full envelope was expected to be used under the baseline scenario. It is difficult to determine whether the previous comments from Lane et al on the PEPP reflected an assessment that economic conditions may not warrant the use of the full envelope, or whether policymakers were attempting to reinforce the ECB's commitment to proportionality in light of the recent GCC ruling.

In addition to the ECB's interpretation of economic conditions and the PEPP envelope, the market was also looking for any additional insight on possible adjustments to the tiering multiplier and the inclusion of 'fallen angels' in the list of eligible PEPP securities. In the case of the former, Lagarde stressed that the two-tiered deposit system had proven particularly effective and, again, indicated that it was appropriate calibrated. Although this suggests that there is no active discussion on raising the multiplier at the moment, eventually the build-up in excess liquidity on the back of the expanded purchase programmes could tip the balance in favour of an adjustment to the multiplier.

There was also no substantial discussion on the inclusion of 'fallen angels' to the PEPP. With Lagarde repeatedly stressing the effectiveness of the successive policy innovations in supporting bank lending to the economy, reducing financial fragmentation risks and more broadly supporting economic activity, there is no urgency to do more at this stage. Any movement on this front is more likely in a situation where periphery-core spreads start to widen again or corporate downgrades (and perhaps even corporate bankruptcies) start increasing.

As we mentioned in our ECB Preview, the more interesting questions (for us, at least) are how the ECB will interpret incoming economic data, how it will navigate the recovery and how it will determine when the coronavirus crisis is over. We suspect that the ECB will continue to downplay rebounding economic data and instead stress 'heightened uncertainty' and the likelihood of persistent demand weakness over the medium term and fundamental economic restructuring. Overplaying the strength of incoming data could conflict with the ECB's central message. That said, a string of strong data outturns in the coming months would make it increasingly difficult for the ECB to stay on point.

In terms of the PEPP, our questions around its lifespan and whether it could eventually morph into a semi-permanent policy tool (or perhaps a similar tool is devised in the future) unsurprisingly remain unanswered. Obviously, it is still early days in terms of the PEPP implementation, so there may not be much market interest in this question for a while. However, the ECB will at some point need to indicate how it will determine when the coronavirus crisis is over and specifically which metrics will be used (as this will determine when PEPP is concluded). Again, we believe it is possible that if staff analysis showed persistent economic scarring from the pandemic, it is conceivable that the PEPP is retained for significantly longer than the current scheduled expiration.

Click here for the full ECB Review or see attached below:

ECB_Review_July_2020.pdf