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

Katharina Utermöhl: At next week’s policy meeting the ECB will deliver on its October pre-commitment upping the dose of monetary policy stimulus with a sizeable QE top-up as well as further banking sector support. The positive news that has emerged on the vaccine front in recent weeks will not fundamentally alter that plan, but in our view should influence the parameters of the December policy decisions. After all, while vaccine breakthroughs will have no sizeable impact on the immediate short-term outlook, downside risks to the outlook for economic growth and inflation in 2021 and beyond have notably reduced as a result. Hence, the ECB’s December decision will be all about striking a balance between a bold policy response that continues to put a firm lid on sovereign and private refinancing costs, while at the same time allowing for sufficient flexibility in case upside risks to the macro outlook materialize as soon as H2 2021.

On the asset purchase front, the ECB – applying key lessons from the pandemic management playbook – should opt for a big and bold announcement next week with flexible implementation across time and policy tools. With borrowing costs in many Eurozone countries at record lows, the key focus of the ECB should be on cementing and extending these favorable conditions in the context of a more protracted economic crisis. A December QE top-up to the tune of EUR500bn should do the trick. In practice, this will mean increasing the ECB balance sheet by another EUR1.6tn in QE purchases in 2021, bringing the total spent on asset purchases between March 2020 and December 2021 to a cool EUR2.4tn. Flexibility is key when it comes to implementation. First of all, the QE reload should not represent a target for but rather a cap on asset purchases. After all, the “threat” of a sizeable QE envelope to be deployed at any time to put out fires in bond markets has, in our view, a greater spread compressing impact than a set monthly pace of asset purchases. Second, given the high uncertainty around the macro outlook, the ECB would get the biggest bang for its buck if it opted for some constructive ambiguity and delivered the QE ammunition in an envelope to be spent in a flexible manner across the APP as well as the PEPP, as deemed most appropriate in the coming months. Meanwhile the ECB should not drop the principle of market neutrality and increase the maturity of bonds purchased under QE nor extend the reinvestment horizon to further compress long-end yields. Instead it should consider an extension of the time horizon for flexible QE purchases (APP & PEPP) beyond end-2021 as we currently anticipate, to demonstrate a firm commitment to an accommodative policy stance while at the same time retaining policy flexibility.

Reinforcing support for the banking sector, where the worst is still to come. just as 2020 was all about tackling liquidity risk, 2021 will be all about mitigating credit risk. Once again monetary policy is not in the policy driving seat here; rather it's up to more fiscal support, for instance via governments extending state-guaranteed loans, and further regulatory forbearance to address the rise in NPLs and capital concerns to make a real difference. Tweaking the TLTRO modalities by itself, is unlikely to boost lending by much, but in tandem with other measures would help soften the expected tightening in credit conditions. Hence, next week the ECB should announce additional tender operations and make the conditions more generous. There are many options when it comes to tweaking the TLTRO modalities; however, we think in particular (i) a lengthening of the period in which banks can borrow at the most favorable rate to at least end-2021, (ii) an increase in the borrowing allowance and (iii) an extension of the TLTRO maturity from three years to four to five years would go a long way in cementing the favorable access to funding.
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