>> GROUP: Shadow ECB Council / EZB-Schattenrat  Katharina Utermöhl

Katharina Utermöhl: Should the ECB introduce another TLTRO and how should it be designed?

Cheap loans to the tune of 400 bn euro will have to be refinanced by mid-2020. Once the residual maturity of the loan is less than one year, they can no longer be considered in the calculation of regulatory liquidity requirements. Hence banks will have to have new financing in place already by mid-2019.
We believe that the ECB will announce a new round of new round of TLTRO funding as soon as its April meeting with an interim assessment given at next week’s March meeting. This new LTRO round is aimed at cushioning concerns about that cliff-edge and in turn at keeping lending conditions loose at a time of cooling macro conditions and elevated political risks.
The liquidity operation could also allow the ECB to normalize policy while avoiding tighter credit condition – notably in countries with still fragile banking sectors such as Italy where in addition to a high share of NPLs banks are also under pressure due to the elevated yield on government debt. However in order to avoid Euro banks becoming too dependent on cheap loans and to please Euro-hawks, the ECB is likely to more restrictions to the TLTRO. In particular it may come with a shorter maturity (2-3yrs) and with a floating-rate so that going forward rate hikes are passed through to the rate on the TLTRO round.

Should the ECB change its Forward Guidance?

Yes. The Eurozone is experiencing a slowdown in economic momentum which is exacerbated by temporary factors as well as elevated political uncertainty. We still deem the development in line with an economic ‘soft landing’. The risk of a recession is in our view low. Nevertheless the weaker-than-expected growth outlook for the Eurozone is calling for some recalibration in the ECB’s forward guidance.
The cat is out of the bag though already: markets have clearly adjusted their interest rate expectations with no hike anticipated before mid-2020. Nevertheless the ECB may chose not to adjust its Forward Guidance in March but rather wait until the April or even June meeting to drop the time-contingent element which refers to the summer of 2019 for several reasons:
1. Much will depend on how the ECB interprets the current economic slowdown. Adjusting the Forward Guidance could be interpreted as the ECB seeing the slowdown as more than a temporary episode (Watch in particular the macro forecast revision to beyond 2019 for hints). Given the elevated uncertainty around the economic outlook, the ECB may choose to wait for more economic data to be released before taking a firm stance, not least since a premature move could risk further pushing out expectations for a rate increase. This may in turn further flatten the yield curve adding additional pressure on Eurozone banks.
2. Current Forward Guidance is only a minimum date that states that rates will stay at the current level throughout the summer or beyond that if necessary but it does not call for action once that date is reached. At some point preferably before the summer it will have to be adjusted but there is no urgency not least since market expectations have already clearly decoupled. Also doing so only two months after the cessation of monthly QE purchases may make that decision look like a mistake and weigh on the ECB’s credibility.

Will the ECB manage to hike rates before the next economic downturn?

Yes. We do not expect a recession to hit the Eurozone over the forecast horizon. In H2 2020 we expect the first timid rate hike in the deposit rate followed by an increase in all rates towards end-2020. Nevertheless the normalization of policy will proceed at a very gradual pace and interest rates will certainly not return to pre-crisis levels for an extended period of time if ever.
Should the economic outlook deteriorate significantly more than expected and policy normalization would be pushed further into the future, the ECB may opt for a technical increase in the deposit rate to alleviate the pressure on banks’ profitability to ensure that the transmission channel is working properly. This would however not be the beginning of a new rate cycle but rather a one-off hike and would require a significant recalibration of the ECB’s communication and forward guidance to avoid an unwanted tightening in monetary conditions.
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