MNI POLICY: PEPP Best Answer To Low Inflation - ECB's Schnabel

By Luke Heighton

     FRANKFURT (MNI) - The European Central Bank has shifted focus from

"firefighting" around market functioning and liquidity provision to dealing with

the implications of the Covid-19 crisis on medium-term inflation, Executive

Board member Isabel Schnabel said Wednesday.

     Europe's economy would likely face "important structural shifts" as a

result of the global pandemic, amid ongoing uncertainty and a "much larger

shortfall in aggregate demand than supply," Schnabel said.

     Here are key points from the online seminar hosted by the Florence School

of Banking & Finance:

     - Given the current "fragile" market environment, the PEPP "remains the

best, and most effective, instrument to respond to the dual risks of a shortfall

of inflation from our medium-term aim and of fragmentation in the euro area,

which threatens the singleness of our monetary policy." 

     - "In the sovereign space," she continued, "monthly purchases in all

jurisdictions will exceed the basis flow if we observe a general tightening of

financial conditions across countries, unusually high volatility or poor

liquidity. In this case, we frontload purchases, following the ECB's capital

key." The share of purchases is raised above the capital key in countries facing

"severe risks of fragmentation."

     - The allocation of purchases across market segments "is also

state-contingent," Schnabel said. "For example, the crisis revealed an

unprecedented need for short-term liquidity by firms as lockdown measures dried

up revenue streams [...] In response to these developments, we decided to shift

a significant share of our purchases to the commercial paper market, and to

longer tenors, in particular."

     - June's Eurosystem staff macroeconomic projections were organised around

three substantially differing degrees of severity, Schnabel said. However all

"assume that the substantial support from monetary, fiscal and labour market

policies is sufficient to avert adverse financial amplification channels."

     - A baseline expectation is that headline inflation will not have returned

to its pre-COVID-19 path by 2022, and core inflation is also expected to remain

subdued in the medium term. "In effect, both the nature of the shock and the

length of the ensuing downturn make it likely that the economy will experience

important structural shifts." Some sectors of the economy "may never return to

their previous size, requiring a large reallocation of capital and labour, also

across borders," Schnabel said.

     - Differences in the speed and extent of capital labour reallocation "if

left unaddressed, risk increasing heterogeneity and fragmentation, further

complicating the conduct of the common monetary policy," Covid-19 could also

lead to a "surge" in protectionism, alongside a "general unwinding of global

supply chains [that] would jeopardise potential output growth across the globe."

In such circumstances, Schnabel explained, "central banks [...] need to take

action before the risks materialise to shelter the economy from further and

deeper harm. Tail risks, in particular, may cause the economy to react in a

non-linear and disruptive way."

     - "In view of the historically weak inflation outlook and the already

accommodative stance," Schnabel said, "the question arises whether our actions

are sufficient and proportionate. In answering this question, the Governing

Council assesses whether the benefits of achieving a faster return of inflation

to levels closer to 2% outweigh the potentially adverse side effects."

--MNI Frankfurt Bureau; +49-69-720-146; email: luke.heighton@marketnews.com

--MNI London Bureau; +44 203 865 3829; email: jason.webb@marketnews.com

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