Recent ECB Decisions and a Preview to PEPP Expansion 

Carraighill follows ECB decisions closely as they impact our idea generation. We write about ECB decisions in our monthly Insights report. This piece reviews recent ECB decisions since December 2020. It is important to note that the European monetary authorities only have a price stability mandate. Full employment (unlike the US) does not play an explicit role in policy formulation. The level of interest rates in an economy is important as a determinant of bank returns. At the zero/ negative bound, bank assets reprice, but the cost of their liabilities does not generally fall below zero.

TLTRO Update in December 2020

The ECB monetary policy meeting in December 2020 increased TLTRO capacity for the system and extended the availability of the -1% TLTRO rate for an additional year. Eligibility for TLTRO has risen to 55% of loans from 50%. This increases the total TLTRO capacity in the system to €3.12tn from €2.85tn (10% increase), of which €1.715tn is utilised as of October 2020.

One negative for banks is that the goalposts have moved for the -1% rate eligibility. Previously, the cut-off for 0% net new lending was March 2020, and it is now October 2020. Why is this important? Banks have to keep net new lending at 0%. That was relatively easy in March as government programmes supported lending during Q2 2020. But can European banks keep SME lending at these same levels for the next 12 months? This remains a significant question mark. Hence why Christine Lagarde called the package “more challenging”.

Other ECB Decisions at the December 2020 Meeting 

  • The ECB announced a further €500bn rise in the size of its PEPP programme, bringing the total to €1,850bn (a figure larger than the annual GDP of Italy). The programme was also extended from June 2021 to March 2022. The ECB outlined that it “will conduct net purchases until it judges that the coronavirus crisis phase is over”.
  • The end of easing of bank collateral requirements (including the acceptance of Greek government debt) was extended to June 2022. This has helped keep Greek government bond yields low as banks now have an incentive to hold them.

ECB Decisions at the January 2021 Meeting

Following the extensive changes in December, the ECB made no significant changes at its meeting on January 21st, 2021.

The ECB Did Not Meet in February 2021

With no ECB decisions taking place, we updated our thoughts on several key questions facing the ECB in 2021:

Why did EUR / USD become a concern for the ECB? The euro had appreciated 13% since the March 2020 lows. The Euro Area is a net exporter, and a strong euro weakens the recovery in exports. This, combined with cheaper imports, weakens inflation prospects.

What can the ECB do to stimulate? The most obvious policy would be to expand the PEPP programme further and match the US levels of asset purchases. The ECB’s balance sheet increased 50% due to the pandemic while the Fed increased by 78%. Even with a higher pace in 2021, the ECB will still be behind. We estimate that a further €1,050bn in PEPP purchases are needed to match the Fed proportionally.

Can the ECB lower rates even further? The second tool available to the ECB is a cut in its deposit facility rate. It has been -0.5% since September 2019. ECB officials have been keen to stress that rates could reduce from here. Dutch central bank president Klaas Knot says, “we’ve explored the effective lower bound but haven’t found it yet. There is still room to cut rates”. The ECB’s own research indicates that rates could fall to -1% before the costs outweigh the benefits (the so-called “reversal rate”).

ECB Decisions at the March 2021 Meeting

The ECB announced that PEPP purchases in Q2 2021 would be at a “significantly higher pace” than Q1. This was in response to rising bond yields in the Eurozone in prior weeks. Monthly PEPP purchases were over €100bn during Q2 2020. This was at the height of the pandemic lockdowns. The following months saw a slower pace of purchases in the range of €50-70bn.

ECB Decisions at the April 2021 Meeting

The ECB made no significant changes. Minutes of the April meeting revealed that some ECB members now see the risks to growth and medium-term inflation as “tilted to the upside”. This renewed discussion over whether the ECB will taper its QE programmes.

ECB Decisions at the June 2021 Meeting

The June ECB meeting kept rates unchanged and PEPP purchase at a “significantly higher pace”. President Lagarde made the following notable observations:

  • M1 is the largest contributor to the growth in M3 in the Eurozone. This reflects a preference for liquid assets.
  • Financing conditions remain stable. Netherlands and Germany saw a strong tick-up in NFC lending, but there is a moderate tightening when those countries are excluded.
  • The ECB doesn’t see inflation in upcoming wage agreements across the Eurozone. They monitor these internally.

An Expansion of PEPP at the September 2021 Meeting Appears Likely

PEPP purchases in May 2021 were €81bn, indicating that this is the new higher pace that will be maintained over the coming months.

The PEPP programme has an envelope of €1,850bn to March 2022. An increase in purchases to above c. €75bn will exhaust the programme entirely, while a return to the Q2 2020 levels of c. €100bn would use the full envelope by the end of 2021.

Government deficits in euro area countries are forecast to total €2,324bn between 2020 and 2022. The figure is likely to be higher now, given continued lockdowns. Public PEPP purchases in 2020 represented 73% of deficits. Assuming this relationship continues, the ECB will need approximately €1,699bn of additional purchases by end 2022. We show that the current envelope falls just short of funding the deficits. This is before deficits in 2023 and beyond are considered. What began as a temporary programme is likely to become a permanent feature of ECB policy.

There have been two envelope expansions to date, one in June 2020 and another in December 2020. These were approximately 200 days before the scheduled end of the existing envelope. The current envelope ends in March 2022. Therefore, it is likely that an expansion will be announced at the monetary policy meeting on September 9th. This should extend the programme to at least the end of 2022.

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