ECB Review: Fiscal First and Foremost

The European Central Bank (ECB) unveiled a package of monetary policy measures that while very much in line with our earlier views, fell short of expectations: markets roiled. The package included:

  • An additional €120 billion of net asset purchases to be distributed over the rest of the year, with increased buying in the private sector - which currently includes covered bonds, corporate bonds and asset backed securities. This amount will be in addition to the currently open-ended €20 billion monthly net asset purchases.
  • Additional Long-Term Refinancing Operations (LTROs) over the coming months to provide immediate liquidity support via banks to companies.
  • Substantially more generous borrowing conditions for the existing Targeted-LTROs. This will include, amongst other easing measures, lowering the borrowing rate for banks to as low as the deposit facility rate minus 25 basis points, implying a cost not higher than -0.75%.
  • Temporary capital relief for banks in reaction to the coronavirus, including allowing financial institutions full use of their own capital and liquidity buffers.

The ECB left interest rates unchanged – a sign that there is little policy flexibility left in this tool since Eurozone interest rates are already at negative levels. We believe this decision was wise: while recent interest rate cuts by the U.S. Federal Reserve and Bank of England may have raised market expectations that the ECB would follow suit, we have long thought further policy rate reductions would only exacerbate what already is a challenging environment for banks and savers, while providing little benefit to borrowers.

Unsurprisingly, the ECB lowered its macroeconomic projections for the Eurozone, relative it its December forecasts, with the Governing Council viewing the risks firmly to the downside. President Christine Lagarde highlighted considerable uncertainty around the latest forecasts, given the ongoing market volatility. Lagarde called on all Eurozone member state governments and public sector institutions to deliver an ambitious and coordinated policy response, stressing that fiscal policy has to be “first and foremost”. Heading that call one day later, Germany’s government delivered a meaningful fiscal package.

This supports our long-held view that the ECB’s interest rate policy has broadly reached its limits. We believe that the central bank will from now rely more on a combination of:

  • Forward guidance to signal that policy rates will stay low for longer.
  • Providing ample liquidity to the economy via the banking sector in the form of long-term refinancing operations;
  • Asset purchases aimed at supporting fiscal policy for as long as necessary.