ECB Review: Fiscal First and Foremost

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.

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.

Relying less on interest rates and more on asset purchases means that, like the Bank of Japan, the ECB has de facto subordinated monetary policy to elected government officials in charge of fiscal policy. In the current environment, there is a need for the central bank to support fiscal policy, rather than offsetting any fiscal stimulus, something that makes us expect a higher fiscal multiplier from any increased government expenditures.

In line with the coordinated monetary and fiscal actions seen in other countries, such as Australia and the UK, it is important to recognise the differences between a single sovereign state and a monetary union such as the Eurozone. Coordinating fiscal policy in a union that lacks a single fiscal authority is more challenging than in a single state – and this partially explains some of the recent spread widening between Italian government bonds and those of other Eurozone countries. The markets are saying that Italy may not be able to ease its fiscal taps as much as it wants.

While Lagarde did not address Italy specifically during her press conference, she later mentioned in a media appearance that the ECB would “be there” to help the country. This could be construed as either flexible deployment of the newly announced net asset purchases or a reference to the ECB’s Outright Monetary Transactions (OMT) policy, whereby the ECB buys member states’ government bonds to safeguard the singleness of monetary policy.

Eurozone governments have to apply for OMT assistance, which is subject to conditionality. This process highlights the challenges of balancing fiscal and monetary policy within a structure in which the monetary union doesn’t have a fiscal match, and those running the fiscal coffers don’t have the monetary control.

What seems clear is that this latest ECB move is a step more towards what we asked ourselves last year: is fiscal the new monetary?

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