David Marsh: ECB Pauses after Easing Sprint

2020-07-21 IMI

This article first appeared in OMFIF Commentary on July 14, 2020. David Marsh, Member of IMI International Committee, Chairman of OMFIF. The pandemic has pushed the European Central Bank into the full glare of global policy-making. On 27 February Christine Lagarde, ECB president, played down the chances of the bank responding imminently to the coronavirus outbreak. In the past 4-1/2 months, the most active period in its 22-year history, the central bank – like the Federal Reserve, Bank of Japan, Bank of England and others – has rapidly expanded monetary easing through targeted bank liquidity operations and massive bond purchases. The multinational central bank has been countering crisis ravages by lowering interest rates on newly issued and outstanding government debt, raising the euro area inflation rate and bolstering recession-hit economic activity. A key aim is to offset risks of euro bloc fragmentation or even break-up by preventing what the ECB coyly calls ‘non-fundamental’ increases in bond yield divergence between weaker countries (principally Italy) and the German-led core. Lagarde is using political skills honed as a former French finance minister and International Monetary Fund managing director to forge complementarity with European Union fiscal activism. The centrepiece is the ambitious €750bn EU recovery fund plan, financed by unprecedented European Commission borrowing, top of the agenda of the EU summit on 16-17 July. On 16 July the ECB’s 25-member governing council will deliberate on action so far and the possibility of more to come. The six-person executive board and 19 national central bank governors are expected to mark a decision-making pause. Here are 10 key issues on their minds.

PEPP might not use full allocation – but ECB keeps options open

Slightly improved economic news – and continued stock market buoyancy – since the ECB decided on 4 June to increase its pandemic emergency purchase programme to €1.35tn from €750bn have engendered some public optimism from ECB policy-makers. Some have speculated that bond purchases might peter out before the scheduled end-date of June 2021, allowing the programme to end without the ECB buying the full allocation. A minority wished to make ‘no more increases’ a stipulation of the 4 June decision, but the ECB as a whole is keeping options open on a further rise. Latest bond purchases appear to be slowing slightly. Activity normally falls in the summer months when markets are thinner. Overall, though, the PEPP has maintained a consistent buying rate of close to €125bn a month, with slightly less than €1tn left to spend. At this rate, the PEPP would run out in February 2021 – prompting forecasts that the ECB might decide another €300bn to €500bn in extra purchases before end-2020.

Tighter language needed on PEPP reasoning

Some governors are pressing the ECB to tighten language on the need for the PEPP, conceived as ‘temporary’ and ‘targeted’, to be concluded when the Covid-19 ‘crisis phase’ ends. The basic economic effect of the PEPP is the same as bond-buying under the ECB’s ‘standard’ non-conventional measures – principally the €2.2tn public sector purchase programme started in 2015, the subject of hotly contested German constitutional court action. The crucial difference is that the PEPP is intended to counter fragmentation risks generated by ‘safe haven’ capital flows out of weaker countries (Italy) to stronger ones (Germany). This accounts for the ECB’s decision in March to lift, for the PEPP only, previous bond-buying restraints, above all the ‘capital key’ rule keeping country bond purchases proportionate to states’ economic size rather than debt levels. Behind the ECB’s jargon permitting ‘fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions’ lie questions of immense significance. The ECB’s wish to check ‘self-fulfilling flight-to-safety dynamics and illiquidity in individual sovereign bond markets’ is sound and justifiable during a crisis but would lose validity when and if developments start to normalise.

Clarity sought on capital key alignment

Suspending the prohibition of selective ECB buying of hard-pressed countries’ debt opens the way to further legal jousting over the possible infringement of the EU treaty ban on ‘monetary financing’. This is the focus of a fresh Karlsruhe constitutional lawsuit by Alternative for Germany (AfD), the main Bundestag opposition party. Eventually, the PEPP and PSPP are expected to be merged. This will be effectively the case when net purchases finish, and already-started (for shorter-term Dutch and German securities purchased in March-April) reinvestment of maturing government bonds builds up from 2021 onwards. Reinvestment is scheduled to last until end-2022. At this time, according to some governing council members, the ECB should bring back the stock of overall PEPP purchases into alignment with the capital key. This implies a fall in underlying purchases of Italian bonds over the next two years. Some governing council members believe this will be difficult to enact. Others dismiss this as a minor inconvenience since, given the overall size of the PEPP, Italian bond purchase overshooting so far has been small in percentage terms.

Possible statement on ‘crisis phase’ duration

Lagarde will need to define at some stage when the ECB conceives the PEPP as no longer necessary. A possible trigger for the end of the ‘crisis phase’ would be when the euro area has seen at least two quarters of high growth, a second, third or fourth pandemic wave is no longer likely, and the EU output gap (difference between actual and potential growth) starts to close. This combination can come at the earliest in spring 2021. Further clarification is required on the rationale behind the PEPP and PSPP. Some governors believe the ECB executive board is trying to shift justification for the PEPP away from an emergency requirement towards the general ECB mandate of producing inflation ‘close to but below 2%’. The ECB speaks about the PEPP upholding ‘the smooth transmission of monetary policy across countries’, as a means both of quelling disruptive short-term capital flows and also of fulfilling the medium-term inflation target. Some view this as a smoke screen for making a temporary programme permanent. Any indication that this is under way would bring criticism from hard money-inclined central bank governors as well as several national parliaments.

Constitutional court action and parliamentary scrutiny

One result of the Karlsruhe resolution is that Jens Weidmann, Bundesbank president, is expected to make quarterly or six-monthly appearances before the Berlin Bundestag finance committee to explain ECB actions. An intensified pattern of interchanges with Bundestag deputies will be through informal invitations – in the same way that he has appeared in past years – rather than as part of a legal process. This will be similar to the ECB president’s regular appearances at the European parliament. These hitherto relatively tame sessions are expected to gain in prominence and sharpness. In other countries, euro area governors are bracing themselves for more formal reviews, reinforcing national parliamentary-central bank communication already taking place. They are resisting overly frequent appearances as well as any hint of legal compulsion. Council members generally accept that they face more legal and political scrutiny as a result of widened measures beyond conventional monetary policy and into areas that overlap with the governmental fiscal domain. Weidmann has clarified his views on the PSPP, which he never supported in ECB parleying but now sees as a legitimate policy instrument, above all because of safeguards against ‘risk-sharing’ introduced in 2015.

Lagarde emerges stronger after climbing down from confrontation

The ECB president has gained credit for adapting initial hostility to the Karlsruhe verdict and adopting a more emollient tone to find a compromise over the legal imbroglio. Governing council members from all quarters praise her diplomatic expertise. She has put behind her the 12 March misstep when she told journalists that the ECB’s job was not to ‘close spreads’ – sparking an Italian bond sell-off and leading indirectly to the PEPP’s birth six days later. In contrast to Mario Draghi, her determinedly aloof predecessor, she has shown conspicuous willingness to engage with more hawkish-minded council members. The 4 June meeting required difficult compromises. Reflecting the depth of the economic problems, she was able to persuade council members opposed to undue largesse to set aside caution in favour of PEPP expansion. On the Karlsruhe deal, she worked with Weidmann to find face-saving phraseology on ‘proportionality’ that satisfied the German government, Bundestag and, consequently, the constitutional court. The Frankfurt-Berlin-Karlsruhe concordat upheld Bundesbank and ECB independence as well as the ECB’s formal jurisdictional accountability solely to the European court of justice. Lagarde was influenced by phone calls with Olaf Scholz and Wolfgang Schäuble, present and former finance ministers, the latter now Bundestag president, constitutionally the No 2 in Germany after the federal president. Additionally, Lagarde helped save Weidmann from the ignominy of possibly being barred by Karlsruhe from further PSPP buying – and then being overruled by Scholz.

Strong link to recovery fund decision

An immediate breakthrough on the EU’s €750bn recovery fund at the 16-17 July EU summit would be positive news for the ECB and would relax pressure on using the full PEPP allocation. Very few expect a deal to emerge that quickly, but Chancellor Angela Merkel , driving the agenda as part of the July-December German EU presidency, will press for a speedy post-summit deal. Fundamental disagreement would be a major blow and would increase Italian-German bond spreads. The recovery fund, guided by Merkel and French President Emmanuel Macron, aims to distribute finance to member states to counter pandemic effects through a mixture of (mainly) grants and loans. This is a key part of the EU’s €2tn-plus Covid-19 support package. On the one hand, ECB officials hail unprecedented coordination between the central bank and European fiscal authorities. On the other, EU-level measures are subject to complex checks and balances. Open issues include mooted extra capital for European Investment Bank lending and further guarantees on the Commission’s planned borrowing, needed for top ranking from rating agencies. Necessary support to back the borrowing for new EU-wide taxes and fundamental discord is proving elusive. And there are disputes over volumes, proportions and allocations of loans against grants in the funding package. ‘The EU is building a big castle,’ says one veteran policy-maker. ‘If one piece breaks down or is not in the right place, the whole structure looks shaky.’

Dutch politics in pole position

Mark Rutte, Dutch prime minister and informal leader of the EU’s ‘frugal four’ alliance linking his country with Denmark, Austria and Sweden, has emerged as a pivotal player in attempts to seal a recovery fund accord. Ahead of Dutch general elections next spring where eurosceptic movements may play important roles, innocuous-looking shifts in Dutch policies can exert major influences on EU decision-making. After visits from Macron and European Council President Charles Michel, Rutte has also conferred with Merkel and other leaders ahead of the summit. His government’s generally hard line opposing unconditional funding for southern states has won electoral backing but he will be wary about becoming a major stumbling block to necessary EU fiscal action. In another sign of smaller countries’ influence in the EU’s increasingly pluralistic set-up, Ireland’s Paschal Donohoe last week beat the favourite in the tussle to become the next president of the Eurogroup of euro finance ministers. Irish Finance Minister Donohoe finished victorious in a run-off against Spain’s Nadia Calviño – who was backed by all the large euro member states – in a ballot among the 19 finance ministers. Donohoe said he wished to provide a ‘bridge’ between the northern and southern states. Ireland has been part of the fiscally conservative Hanseatic League nations but has also supported centralised euro area borrowing to shore up weaker states.

Council wins influence over bond allocations in governance move

In a test of Lagarde’s conciliatory abilities, some governors are grumbling that the executive board has amassed too much power at the expense of the governing council. This alleged imbalance gained ground during the Draghi era, partly as a result of council passivity – but some governors are now mounting a rearguard action. During the high point of the pandemic, given the need for speed and remote conferring via video conferences, centralised activism was inevitable. Now that the most intense turbulence seems to have passed, the governing council is getting more involved in allocating monthly PEPP allocations, earlier the preserve of the executive board and various ECB committees. The council became involved for the first time in discussions on allocations in June. The board and ECB staff still hold considerable sway, since day-to-day fluctuations are permitted, allowing for market movements and other factors such as changes in debt issuance schedules. In another milestone in ECB governance, there will be considerable jockeying over the succession to Yves Mersch, a veteran board member who steps down in December after eight years. Mersch, responsible for microprudential supervision and legal services, has been ever-present on the governing council since the ECB was established in 1998, when he was governor of the Luxembourg central bank. Many smaller countries wish to field candidates for the role, under a succession contest likely to start in September. A representative of one of the central and eastern European states that joined in the last decade may take the job.

Disparate recovery poses challenges

The European recovery from the second half of 2020 onwards is likely to show strong disparities. The European Commission on 7 July forecast an 8.7% euro area GDP decline for 2020, followed by a 6.1% increase next year. Germany, the Netherlands and Austria are likely to record respective GDP declines of 6.3%, 6.8% and 7.1% this year and rises of 5.3%, 4.6%, and 5.6% next year. Italy, France and Spain, by contrast will register falls of 11.2%, 10.6% and 10.9% this year and rises of 6.1%, 7.6% and 7.1% next year. This would bring a 4.1 percentage point growth disparity between Germany and Italy by the end of next year, against 2.8 percentage points for the gap with Spain and 2 points for France . After the 2008-09 crisis, similar divergences emerged, proving durable over 10 years. The gaps are exacerbated by wide discrepancies in public debt between northern and southern Europe, allowing creditor countries to finance economic revival at more favourable interest rates. The variance has been underlined by a record widening of the Bundesbank’s Target-2 ECB creditor balance of €995bn at end-June, accompanied by sharp increases in the debtor balances of the Banca d’Italia and Banco de Espana. Some of this has been driven by the ECB’s bond-buying and liquidity measures. These are indicators of underlying tension. Unless offset by full enactment of planned EU fiscal rebalancing, some governors believe these disparities will become more important as recovery gains momentum.

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David Marsh: ECB Pauses after Easing Sprint

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