ECB Interest Rate Decision Preview: The bond buying panacea

• Central bank expected to expand the €750 billion Pandemic Emergency Purchase Program.
• No change expected in the main refinance rate.
• ECB may commit to reinvesting program proceeds for an extended time, and buy junk status bonds.
• European real-time economic indicators and business surveys have begun to recover.
• Euro has gained 3.6% against the dollar since May 18.

The European Central Bank is widely expected to announce an increase in its stimulus measures designed to counter the economic and financial damage from the pandemic when it meets on Thursday in Frankfurt.

An expansion of the €750 billion Pandemic Emergency Purchase Program (PEPP), the bank’s bond buying effort launched in March, will likely be accompanied by the long-standing warning that the main burden of European recovery must be borne by the national governments.

EU recovery fund

President Lagarde, who has repeatedly urged European governments to provide more support to the bloc’s faltering economy, will no doubt praise the EU’s €750 billion recovery plan intended to help cushion the deep economic slump anticipated this year. The EU Commission will distribute two-thirds of the monies in grants, as per the demand of France and Germany, and the balance in loans.  

The ECB will update its economic estimates on Thursday and Ms Lagarde has said she expects the eurozone to contract between 8% and 12% this year.  As the lockdowns on the continent end economies must necessarily rebound though the crucial questions are speed and extent. business surveys and usage indicators like electricity consumption, traffic and travel hint that the recovery has already begun.

ECB bond program

Until the recent agreement on the EU-wide stimulus effort, ECB bond buying had been the sole program to mitigate the crippling impact of the pandemic economic shutdowns.  But even with the new EU plan the ECB scheme will remain on the front-line as the proposed Commission administered spending will not really begin before 2021 and is designed to spin out over several years.   The bank will also remain the main backstop to prevent the banking and financial system from slipping into another crisis.

EMU debt

The debt to GDP ratio across the eurozone is expected to be over 100% by the end of this year, with the top five nations in descending order Greece, Italy, Portugal, France and Spain.   

CNBC

One of the chief purposes of the ECB bond program was to help the heavily indebted countries keep their interest costs low especially in light of the sharp increase in deficits and debt issuance this year from the pandemic.

The ECB expects an increase of eurozone sovereign debt by €1 trillion to €1.5 trillion and an average budget deficit of 8%.  The EU also plans to borrow €750 billion through the new recovery fund. Long gone are the 3% deficit and 60% debt to GDP limits of the Stability and Growth pact

EMU inflation

Inflation in the eurozone dropped to 0.1% annually in May due to the plunge in oil and energy prices.  The ECB tracks headline price changes, including food and energy costs and has a target of just below 2%. In March the bank projected a 1.6% inflation rate by 2022, that forecast will most likely be reduced in Thursday’s economic estimates.

In contrast the Federal Reserve tracks and targets core prices, without food and energy, though also aiming for 2%.  Neither central bank has been successful in the post-financial crisis decade in bringing inflation to their target.

Conclusion

No surprises are expected from the ECB conclave or in President Lagarde’s press conference. The additional PEPP limits and the cheerleading Ms Lagarde will give to the new EU program should keep the euro buoyant.

The united currency has gained 3.6% against the dollar in the last two weeks returning to its immediate pre-panic high. With the pandemic receding and economies around the world restarting the dollar has surrendered the balance of its risk-aversion premium.

As with the US Federal Reserve the ECB is operating at the limit of the economic demand and with recovery in sight the future policy will likely be patience.