What will the ECB do next?
The recently released account of April's policy meeting offered some unusually explicit hints that additional stimulus measures would follow at the subsequent policy meeting on 4 June. The Governing Council was "fully prepared to increase the size of the Pandemic Emergency Purchase Program (PEPP) and adjust its composition, and potentially its other instruments, if, in the light of information that became available before its June meeting, it judged that the scale of the stimulus was falling short of what was needed".
The flexibility of the PEPP makes it a more appealing option for the Governing Council than the Asset Purchase Program (APP), while its temporary status should help to limit dissent, though a large increase in the "envelope" would be likely to run into opposition, nonetheless. Concerns were expressed about fiscal dominance in April's meeting account and this will remain a bone of contention for the more hawkish members.
Market expectations ahead of June's meeting appear to be centered on an uplift of around EUR400bn (on top of the initial EUR750bn "envelope") which is a reasonable expectation in our view, though we see a possibility of an even larger increase, extended into 2021, against a backdrop of extreme contractions in GDP and persistent downward pressure on already uncomfortably low inflation rates.
DFR reduction less likely
The phraseology used in the account of April's meeting left open the possibility of other policy instruments being deployed and the conspicuous absentee from the various measures announced since the COVID-19 shock is a reduction in the deposit facility rate (DFR), currently at -0.50%.
We retain a 10 basis point reduction in our baseline forecast for June's meeting, though the probability of this happening as soon as June has diminished for various reasons including: the emphasis on the PEPP, continued weakness of the EUR/USD exchange rate and ongoing concerns about potentially adverse implications for the banking sector.
In the absence of a cut in the DFR on 4 June, we would expect the ECB's forward guidance on policy to retain an easing bias in order to avoid any unwelcome upward pressure on the exchange rate and to signal that policy ammunition is not exhausted. Indeed, more generally, the ECB's communication should again highlight the willingness to continue to expand the range of stimulus measures.
ECB open to bold action…
One of the encouraging aspects of April's meeting account was the assertion that the Governing Council was willing "to adapt its tools and to implement them forcefully as needed" and was ready to take "bold, innovative action to safeguard the smooth functioning of the transmission mechanism and the integrity of Monetary Union". The flexibility of PEPP implementation was mentioned explicitly in this regard.
…but too little, too late?
This being said, we remain concerned that the ECB's policy responses are arriving rather late in the day when it comes to inflation and inflation expectations. Underlying inflation rates and market-derived measures of inflation expectations were uncomfortably and persistently low even before the precipitous economic downturn now in train. Echoing the Japanese experience, while core inflation picked up during economic expansions, the peaks in each of the cycles became progressively lower.
The lack of a sufficient buffer against deflation is a particular concern at present. An inflation targeting central bank needs to set a sufficiently high floor for underlying inflation, and deliver on this objective, in order to provide a sizeable buffer. The goal is to reduce the risk of inflation falling so close to zero that if the economy is then hit by a sudden, sharp drop in demand, it becomes susceptible to deflation. Policy makers in the eurozone have not done enough, early enough, to reduce this risk.
Deflation risks persist
The deep recession we expect in the eurozone due to the COVID-19 virus shock has reignited our concerns over the risk of deflation. We are tracking a deflation vulnerability index which we developed based on a framework pioneered by the IMF. While it currently suggests the risk of deflation in the eurozone is low, there are significant lags following an adverse shock and we expect the vulnerability index to increase over the coming quarters.
One of the lessons from Japan's experience is that a proactive monetary policy stance is essential, complemented by a more stimulatory fiscal stance. This raises alarm bells for the eurozone. In the immediate aftermath of the Global Financial Crisis (GFC), from 2009 onwards many central banks moved quickly to implement large-scale asset purchase programs.
In contrast, the ECB only commenced its large-scale asset purchases from March 2015, more than six years down the line and only following another severe adverse shock in the form of the eurozone crisis in 2011-12. The ECB also opted to raise its policy rates amid the escalating crises in both 2008 and 2011.
The sub-optimal policy responses of the ECB reflected various factors and hindrances, including opposition to large-scale sovereign debt purchases from some Governing Council members and question marks about their legality. Fiscal space has also been constrained in many eurozone member states, while those with the most room for maneuver (e.g. Germany) have been reluctant to use it absent a severe shock.
Notably, concerns about deflation risk featured more prominently in the account of April's policy meeting. It was highlighted that since the start of the coronavirus pandemic, the likelihood of inflation being below zero had increased substantially according to option-implied probabilities, pointing to a significant risk of deflation. It was also pointed out that market-based indicators of inflation expectations appeared to be reacting more to developments in actual inflation, suggesting that inflation expectations were becoming less well anchored.
The ECB's acknowledgement of such risks is welcome, as is the additional policy accommodation to try to ward off the threat. But it might simply be too late.