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Slowdown in euro area economy forces ECB to 'recalibrate' policy


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Slowdown in euro area economy forces ECB to 'recalibrate' policy

The European Central Bank will reevaluate its policy instruments in response to a "fairly dark" outlook for the euro area economy as member states lock down their economies amid a second spike in COVID-19 cases, ECB President Christine Lagarde said after the bank's latest monetary policy meeting.

The euro area economy contracted by 11.8% quarter on quarter in the second quarter of 2020, and while there has been a subsequent recovery, Lagarde said another slowdown became apparent in September, and the bank expects that the growth figure for the fourth quarter "will be on the downside."

The continued spike in COVID-19 cases saw European equities fall to their lowest level in over five months on Oct. 28, with the STOXX 600 retreating 2.95% as 97% of the index's constituents traded lower.

While the ECB decided against taking action at its Oct. 29 meeting, Lagarde made clear that all policy tools are on the table at the December meeting. "We will use the flexibility of everything we have, and we will recalibrate using the comprehensive data we will gather," Lagarde said.

It would not be the first time the ECB has adjusted its response as the health crisis has unfolded. The ECB increased the Pandemic Emergency Purchase Program, or PEPP, at the June 4 meeting by €600 billion, to €1.35 trillion, and extended its timeframe beyond December to at least June 2021.

Rate cuts 'exhausted'

"[The] ECB is clearly concerned about the economic outlook. What ECB actually can do about it — but to be the backstop — which they haven't done already is a non-trivial question," tweeted Piet Christiansen, chief ECB strategist at Danske Bank.

Lagarde noted that headline inflation is being dampened by muted price pressures, significant slack in labor and product markets, and low energy prices, and it is likely to remain so until early 2021. While fiscal policy measures are supporting households and firms, consumers are cautious.

But the prospect of further rate cuts to boost consumption is unlikely, according to James Sym, manager of the ES R&M European fund. "That policy mechanism to stimulate demand is totally exhausted and the ECB understands that the negative effects, for example on the banking system, outweigh any minor signaling benefit. Other monetary policy measures will be preferred such as asset purchases and direct support for banks and SMEs," Sym wrote in a market commentary.

Other analysts suggest further asset purchases are more likely.

"To ensure convergence of the inflation projection to the target, asset purchases are likely to have to increase. This, in turn, would support bond valuations, or at least prevent a rapid rise in interest rates, similar to the ECB's intentions in spring. It is unclear at this stage whether expanding the PEPP will be the best course of action in this context," Andreas Billmeier, sovereign research analyst at Western Asset, wrote in a market commentary.

As of mid-October, the ECB's balance sheet stood at €6.7 trillion, up from €4.7 trillion at the start of 2020. But by comparison with the Federal Reserve in the U.S., the ECB has so far been restrained, with that 45% increase much lower than the 72% hike in the Fed’s balance sheet.

"The door for December action is wide open. Let’s hope that the situation doesn’t worsen further so that the ECB has to rush through the door earlier than planned," wrote Carsten Brzeski, global head of macro at ING.