Too soon to talk about ECB tapering

The US may be taper-whispering, but the European Central Bank cannot return to its pre-pandemic level of bond buying until at least the end of 2022, even if the recovery continues, argues Crédit Agricole CIB Eurozone economist Louis Harreau. Yet Europe may need to follow the US’s lead in combined fiscal and monetary policy should a renewed crisis emerge.

The Fed has revised upward its expectations for a rate hike in 2023 and, as explained by chair Jerome Powell, it has started “talking about talking” about a future tapering of its QE. We might be at the beginning of the process of monetary tightening in the US — should the ECB follow the Fed?

As Christine Lagarde has repeated several times, the Eurozone and the US are not in the same situation and, consequently, the central banks must act differently. The difference between the two economic zones lies, in my view, in three factors:

Firstly, the US entered the pandemic in a better situation than the Eurozone: GDP was at — if not above — its potential, the economy was at full employment, and inflation was sufficiently high. On the other hand, the Eurozone was still struggling with the scars of its double-crisis of 2008 and 2011, with elevated unemployment and low inflation.

Secondly, the pandemic has had a harder impact on the Eurozone economy than on the US because of the spread of the virus, but also the measures taken, and to a lesser extent a more efficient start to the vaccination campaign.

Thirdly, and more importantly, the major difference between the US and the Eurozone is fiscal policy: the US government reacted with an extremely strong fiscal response. Whereas the Eurozone, despite the involvement of both national governments and the EU (with the Next Generation EU (NGEU) recovery package), provided a relatively limited fiscal package.

Because of these three elements, US GDP reached its December 2019 level in June 2021 and, more surprisingly, could exceed the pre-pandemic trend in the coming years. On the other hand, the Eurozone is only expected to reach its 2019 level in the second quarter of 2022, and should remain at a low growth trend in the coming years. This largely explains why the two central banks are in very different situations: on the one hand, the Fed is starting to think about a gradual reduction of its monetary support, while on the other hand, the ECB should be increasing its monetary policy support.

You mention increasing monetary policy support, yet the ECB started the discussion about tapering the Pandemic Emergency Purchase Programme (PEPP) at its June meeting — even if it decided against tapering.

With PEPP, the ECB has adopted a new approach to monetary policy. With this tool, instead of providing broad monetary support — like it does with rates and the Asset Purchase Programme (APP), for example — the ECB specifically targets financing conditions. The idea is that during the pandemic period, the monetary stance cannot take the same approach as before. Consequently, PEPP was not created to ease monetary policy, but rather to ensure that financing conditions remain favourable. This was the case at the very beginning of the crisis, when the ECB used PEPP to compress sovereign spreads and revive the commercial paper market, and it is also the case currently, with the ECB using PEPP to compress yields and rates to ensure that financing conditions for households and SMEs remain as favourable as possible.

Under this scheme, the ECB calibrates the pace of PEPP purchases not necessarily depending on the economic and inflation outlook, but rather on financing conditions relative to this economic outlook. This explains why the ECB has from the very beginning of the programme been constantly discussing the pace of PEPP purchases, sometimes to increase it and sometimes to reduce it.

Consequently, a reduction in the pace of PEPP in the future would not necessarily mean a “tapering”, given that it would not necessarily indicate a gradual and definitive end to the programme.

But we can still anticipate PEPP ending at some point?

Yes — and relatively soon, in our opinion. As its name indicates — Pandemic Emergency Purchase Programme — PEPP is strictly linked to the pandemic, so it should no longer exist when the pandemic is over. Now, the discussion at the Governing Council is when the “pandemic period” will be over: is it when the Eurozone will be sufficiently vaccinated, or when the economy will be back to its pre-pandemic level? For me, the pandemic period is longer than that: the pandemic period will be over when the Eurozone economy will have healed from all the scars resulting from the pandemic: with GDP not only returning to its pre-pandemic level, but also having caught up to the potential level that it would have reached without the pandemic. This is the only way to ensure that the ECB has been accommodative enough and that it can go back to its “conventional unconventional” monetary policy, i.e. what it was implementing before the pandemic.

Louis Harreau, CACIB

There is another matter to take into account: fiscal policy. The ECB is calling for governments to implement more proactive fiscal policy to support the recovery, and at the same time, it is warning about the risk of removing fiscal measures too early. Under the current outlook — and even more so if governments listen to the ECB — this means that public bond issuance will remain heavy in 2021, of course, but also in 2022: public deficits will remain large, and we also have to add the NGEU issuance. In this context, the end of PEPP purchases in March 2022, as is currently expected by the ECB, would trigger a demand/supply imbalance and would increase sovereign yields. Not only would this worsen public finance balances, but as sovereign yields are benchmarks for other financing conditions, this would also tighten financing conditions.

That said, this is the theoretical perspective — we know that some members of the ECB’s Governing Council want to end the PEPP as soon as March 2022, because they worry about overly accommodative monetary policy, and also to ensure the consistency of the tools: PEPP was designed only for the pandemic.

What could be the result of this discussion?

For me, the ECB cannot return to its pre-pandemic monetary policy (APP purchases of €20bn a month) before December 2022. This means it has two options: either it increases the PEPP envelope (currently €1,850bn) and extend the programme until the end of 2022, or it ends PEPP in March 2022, as expected, but at the same time increases the monthly pace of the APP to €50bn or €60bn until the end of 2022. The two options would have more or less the same consequences — the idea is simply to absorb part of the net issuance of public bonds. In my opinion, using PEPP more is the simplest option: PEPP is more flexible and the built-in limits of the APP do not bite in PEPP, consequently an increase in the PEPP would be a one-off and would not have longer term consequences on the ability to source enough bonds in the APP.

Regarding the APP, it has been out of the headlines since the announcement of PEPP, but the programme is still running.

Indeed, the ECB continues to buy €20bn of bonds — public, corporate and covered bonds — every month, and the programme is open-ended. Unlike PEPP, this programme aims to bring inflation back towards the ECB’s level. This means that it is likely to continue for a very long time. We assume that the ECB will continue the APP until core inflation exceeds 1.4% on a permanent basis — i.e. the level at which it would start being more comfortable with the inflation outlook. This means, according to our projections, that the ECB would end the APP only at the end of 2024.

Since the ECB explained that, like most central banks, it will end its net purchases before hiking its rates, we do not expect a rate hike before the end of 2025.

This is the basis of our scenario for the ECB’s monetary policy: an intense monetary policy until the end of 2022 — until the end of the pandemic period — with an extension of PEPP or an increase of the APP; then an accommodative monetary policy (with an APP of €20bn a month and a deposit rate at minus 0.5%) until the end of 2024, before very gradual normalisation of monetary policy, with the end of net purchases followed by the beginning of rate hikes.

There is another tool we have not discussed: TLTROs.

Most of the time, TLTROs are underrated by investors and analysts. They have provided extremely strong monetary support to the Eurozone since their creation in 2014, allowing banks to have access to cheap funding in exchange for their commitment to lend to the private economy. During the pandemic, the ECB transformed these tools to make them more efficient, both to ensure financial stability and to enable banks to provide favourable financing conditions to borrowers. Cutting the rates to minus 1% for 12 months and then 24 months ensures that all banks benefit from the same extremely favourable financing conditions. It also encouraged banks to lend more proactively to the private economy. Furthermore, as the operations are collateralised, TLTRO acted as backdoor QE, since banks purchased bonds on the market to use them as collateral at the ECB.

As for the future of TLTROs, we believe it is likely to look like the other aspects of the ECB: as the pandemic recedes, the ECB is likely to stop the extremely favourable operations after the last one, expected in December 2021. However, as with the other tools (APP and negative rates), the ECB is unlikely to stop TLTRO anytime soon. It will probably announce new operations — less favourable than TLTRO III, but still very attractive — in the course of 2022.

We are discussing the modalities of the ECB’s gradual exit from its very accommodative monetary policy, yet inflation is not expected to reach the ECB’s target anytime soon. And that’s without even considering the potential for a renewed crisis to derail the recovery and the increase in inflation. What more could the ECB do?

Two elements are certain. On the one hand, the ECB is not out of options: it can still cut its rates, it can still buy more bonds in its purchase programmes, and, furthermore, with the TLTROs, it has shown that it has no limits in its ability to support credit lending. But on the other hand, it is also clear that all these tools have diminishing returns, and that at a certain point, the negative effects will overcome the positive ones — we are far from this point, however.

There has been a lot of discussion about “helicopter money” or about public debt cancellation by the central bank. We do not believe that these are adequate answers because: they are forbidden by EU Treaties; they would force the ECB to overstep its prerogatives; and, more importantly, they are economically suboptimal.

The true answer to the current suboptimal situation and to a potential future crisis is outside the remit of ECB — or at least, the ECB could only play a part, as it would require cooperation between fiscal and monetary policy. The example of US fiscal and monetary policy during the pandemic is a good guide — and the economic results could provide answers about the efficiency of such cooperation. Fiscal policy supported by a central bank knows no limits as long as inflation does not bite. Consequently, if the Eurozone faces another downturn that would put downward pressure on inflation, coordination of fiscal and monetary policy would be the answer. Of course, the issue for the Eurozone is that there are 19 fiscal policies and one monetary policy. The conclusion is clear: the Eurozone needs more fiscal integration. A first step has been made with the NGEU, but the EU will have to integrate further to face new shocks in the future.

Main photo credit: Martin Lamberts/ECB/Flickr