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

Katharina Utermöhl: 1) What should the ECB do to support the economic recovery? Should it expand its asset purchases?

The ECB should soon pull new tricks out of its hat in an effort to keep a lid on debt sustainability concerns and prevent unwarranted financial fragmentation. After all, national safety nets spun by governments across the Eurozone in an effort to shield the private sector from more structural economic damage – including a spike in unemployment and corporate insolvencies – will lead to a dramatic rise in public debt. Compared to the new debt to be issued in the coming months by Eurozone governments – the four heavyweights Germany, France, Italy and Spain alone look set to issue about €1 trillion in long-term debt in 2020 – the ECB’s €750bn Pandemic Emergency Purchase Program is starting to look decidedly less mighty. Already the ECB is engaging in a European form of yield curve targeting, with the objective of its monetary policy perhaps not to “close the spread” but to – increasingly explicitly – cap the Italian spread at around 280bp to 300bp. In order to defend this line in the sand, it ECB should implement the following measures:

a) Double-down on PEPP: If the ECB continues to deploy its Pandemic Emergency Purchase Program (PEPP) envelope at the current pace, it will be fully used up by end-September. Therefore, in an effort to reduce uncertainty and to calm any market concerns about a PEPP-cliff edge, the ECB should announce a doubling of its PEPP in size as well as duration at the June meeting, - justified by a sharp downward correction in its growth and inflation projections. Our model for the 10y BTP spread shows that as a result the spread would indeed stabilize at around 230bp until end of 2022. In practice this will mean adding a cool €2.2 trillion in asset purchases to the ECB’s balance sheet between March 2020 and December 2021.

b) Buy fallen angels: Following up on the ECB’s decision to accept “fallen angels” i.e. bonds that lose their investment-grade credit rating as collateral, we expect the ECB to soon announce that it will also buy “fallen angels”. Even though the relaxation of collateral requirements has already helped, this additional step is still necessary to calm markets given an expected wave of sovereign and corporate rating downgrades particularly as far as Italy is concerned.

Meanwhile with regards to the key interest rates, we thing the end of the road has been reached. The ECB should not cut interest rates any further. Beyond the short-term, we believe that monetary policy will have to remain accommodative throughout 2023. The monthly pace of asset purchases should be gradually reduced to €20bn in 2023, but low rates and extensive banking support will still be necessary given the legacy of the Covid-19 crisis, including below pre-crisis trend growth and inflation dynamics, elevated debt levels in the public and private sector and lingering NPLs on banks’ balance sheets.

2) How will the current crisis and the fiscal and monetary response to it affect inflation in the medium to long-term?

The medium-term impact of the corona crisis on the inflation outlook will probably depend to a large extent on the extent to which monetary and fiscal policy returns to the old rules of the game after the crisis. At present, the state is shouldering the much higher risk for the private sector in order to keep long-term damage in check. Since the government aid measures consist mainly of loans and loan guarantees, both public debt and that of the companies that take advantage of these aids will rise rapidly in the coming months. While now is not the time to worry about the growing debt, which is certainly the lesser of two evils compared to the expected increase in unemployment and corporate insolvencies without a safety net, once the crisis is over, dealing with the accumulated mountains of debt could prove to be a sticking point. There are basically two ways to pay them off: through higher real growth, i.e. productivity growth, or through higher inflation. However, experience from the financial crisis has shown that the accumulated debt in many countries has not been subsequently reduced. On the contrary: global debt reached a new record high in 2019. Since the odds of a productivity boost in the near future are rather low, I assume that the second path will ultimately be taken: In order to reduce debt burdens, higher inflation will be accepted, which will be justified by lower unemployment and higher economic growth. Such a strategy is not without risks: if close coordination between fiscal and monetary policy becomes a permanent feature, the independence of the ECB could be increasingly called into question, and thus also to what extent it can still fulfil its primary mandate of maintaining price stability.
>> Kontakt