MNI POLICY: ECB Lane Says Depo Rate Cut Option if Need: Blog

     LONDON (MNI) - The following is the text of a blog by ECB Chief Economist

Philip Lane explain Thursday's policy moves.

     In this blog post, I will explain the analytical framework underlying the

comprehensive package of monetary policy measures that the Governing Council

decided yesterday. The spreading of the coronavirus is a severe economic shock

to the world and euro area economies. In addition to the much-discussed

potential interruption of supply chains, the necessary containment measures that

are being introduced in many countries imply both a temporary decline in

production and the cancellation or postponement of many expenditure plans. In

overall terms, this situation has an immediate adverse impact on the economy.

     In fact, the latest survey data measuring current global activity have

nosedived (see Chart 1). Moreover, as lockdown measures are implemented more

broadly and for a longer duration, a more substantial and longer lasting

downturn is likely. At the same time, success in containing the virus - notably

through an appropriate policy response - will ultimately allow a return to more

normal economic conditions.

     The clear aim for policymakers should be to mitigate the impact of the

shock, by countering pro-cyclical amplification dynamics and muting propagation

forces that might convert a temporary shock into a decline in long-run economic

performance. For governments, in addition to meeting the immediate public health

challenges that are needed in order to containing the spread of the coronavirus,

an ambitious and coordinated fiscal policy response is required to support firms

and workers at risk due to the economic fallout from this shock. This should

include measures such as credit guarantees that limit the threat that a

temporary shortfall in revenue would constrain the subsequent recovery of firms

that were in good shape before this shock occurred. It should also include

support for workers that face temporary declines in wages. More broadly, the

overall macroeconomic orientation of fiscal policy should ensure that the

decline in aggregate private-sector expenditure is not amplified in a

pro-cyclical manner. Accordingly, the Governing Council strongly supports the

commitment of euro area governments and the European Institutions to joint and

coordinated policy action.

     Monetary policy also has a vital role to play. The initial supply side

shock from the coronavirus outbreak has clearly morphed into a demand shock that

deeply affects activity across all sectors of the economy. Moreover, the

economic ramifications of the coronavirus have already been amplified by a

tightening in financial conditions, especially through the decline in stock

prices, rising yields in some asset classes, together with the appreciation of

the euro (Chart 2). This risks triggering a material deterioration in financing

conditions in the euro area.

     Our monetary policy response to this severe (yet ultimately temporary)

shock has three key elements: first, safeguarding liquidity conditions in the

banking system through a series of favourably-priced LTROs; second, protecting

the continued flow of credit to the real economy through a fundamental

recalibration of the TLTROs; and third, via an increase in the asset purchase

programme, preventing that financing conditions for the economy tighten in a

pro-cyclical way.

     It is essential to ensure that liquidity is provided on generous terms to

the financial system, in order to avoid the well-understood spiral effects if an

adverse economic shock is amplified by liquidity shortages: in addition to our

existing regular liquidity operations, the new long-term refinancing operations

(LTROs) provide new lines of funding at a low rate (the deposit facility rate) )

of -50 basis points. Such liquidity measures are especially important under

conditions of heightened uncertainty and when the coronavirus shock also poses

operational risk challenges for many participants in the financial system.

     Especially given the revenue shortfall that is facing small and

medium-sized enterprises (SMEs) and the income shortfall that is facing

households, supporting credit supply can avoid the credit-crunch dynamic by

which banks pull back from lending at the same time as the demand for credit is

increasing. Under the new terms for TLTRO III, we have increased the volume of

funds that banks can borrow from us in order to provide credit to firms and

households by more than EUR 1 trillion. This raises the total possible borrowing

volume under this programme to almost EUR 3 trillion. Banks can borrow at the

most favourable rates we have ever offered, provided that they continue to do

their job of extending credit to the private sector. An important innovation is

that, by setting the minimum borrowing rate at 25 basis points below the average

interest rate on the deposit facility, we are effectively lowering the funding

costs in the economy without a generalised reduction in the main traditional

policy rates.

     Overall, the new conditions on the TLTRO help to significantly ease the

funding conditions that determine the supply of credit provided by banks to

firms and households. In particular, this will support bank lending to those

affected most by the spread of the coronavirus, and especially SMEs. In order to

ensure that banks will be able to make full use of our funding support, we will

also investigate further collateral easing measures. Also, as demonstrated by

this revision, it should be clear that adjustments to the parameters of the

TLTRO programme provides an agile instrument in our monetary policy toolbox, if

the circumstances so warrant.

     In this context, the measures taken by the ECB's Supervisory Board also

provide welcome temporary capital and operational relief to euro area banks.

These decisions show that the improvements in the regulatory framework achieved

over the past years, allow relaxing requirements on banks in a counter-cyclical

way, thereby, complementing well our monetary policy decisions.

     It is essential to ensure a sufficiently-accommodative monetary stance,

especially in an environment of high uncertainty and elevated financial

volatility. The addition of an envelope of an extra EUR 120 billion to our asset

purchase programme (APP) over the rest of 2020 helps to ensure that the euro

area risk-free yield curve - as captured by the overnight index swap (OIS) curve

- supports favourable financial conditions for the real economy. The role of the

APP - both the private-sector purchase programmes and the public sector

securities programme - is especially helpful during a "flight to safety" episode

when investors switch across assets on the basis of the correlation patterns by

which some assets are classified as "safe havens" that gain value during

risk-off episodes. Under such conditions, there are deviations from the typical

co-movement patterns between the GDP-weighted average sovereign bond yield curve

and the respective OIS rates, which call for flexibility in the implementation

of our asset purchase programme.

     The addition of this extra envelope in the asset purchase programme

demonstrates that it is a priority for the Eurosystem to show a more robust

presence in the bond market during phases of heightened volatility. Moreover, we

are committed to use the full flexibility embedded in the APP to respond to

current market conditions. This means that there can be temporary fluctuations

in the distribution of purchase flows both across asset classes and across

countries in response to "flight to safety" shocks and liquidity shocks. Such

deviations from the steady-state cross-country allocation are within the remit

of the programme, so long as the capital key continues to anchor the total stock

of our holdings in the long run.

     We will not tolerate any risks to the smooth transmission of our monetary

policy in all jurisdictions of the euro area. We clearly stand ready to do more

and adjust all of our instruments, if needed to ensure that the elevated spreads

that we see in response to the acceleration of the spreading of the coronavirus

do not undermine transmission.

     Let me touch on a final aspect. You may wonder why, unlike many other

central banks in recent weeks, the ECB did not lower its key policy rates.

Decisions about the short-term policy rate should be understood in the context

of the nature and expected duration of the shocks facing the economy, as well as

the transmission lag of the different monetary policy instruments. For instance,

a move in the short-term rate is typically most powerful if it is expected to be

persistent, given the importance of the expectations channel in determining the

influence of the short-term policy rate on the overall yield curve. This

persistence channel is less relevant in the context of the spreading of the

coronavirus. While this major shock is hitting us at high speed, our baseline

scenario is that it will be ultimately temporary in duration. Accordingly, we

concluded that an easing of the monetary stance through the additional asset

purchases and the considerable support for credit supply through the revised

TLTRO programme is the more appropriate response. However, it should also be

clear that, although the deposit facility rate (the main short-term policy rate)

was maintained in yesterday's decision at its current value of minus 50 basis

points, the Governing Council retains the option of future cuts in the policy

rate, if warranted by a tightening in financial conditions or a threat to our

medium-term inflation aim.

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

[TOPICS: M$X$$$,M$$EC$]