First scheduled rate decision at a major central bank since virus hit global economy
Christine Lagarde will this week face the stiff challenge of convincing investors, businesses and households that the European Central Bank has the tools it needs to respond to the coronavirus.
As the first major central bank to hold a scheduled policy meeting since the full impact of the virus on the global economy took shape, the ECB president must on Thursday outline a response after the US Federal Reserve enacted its first emergency rate cut since the height of the financial crisis in 2008.
Until just a few weeks ago, it had seemed the ECB’s governing council would be responding to a brightening economic outlook. After two years of sagging growth and inflation the eurozone economy seemed to be turning a corner at the start of this year, with rebounding factory orders and improving business sentiment.
That was before virus spread to many European countries and threatened to leave their economies in tatters.
The virus is hitting exports to China and threatens to disrupt the supply of crucial parts from Chinese companies. Fear of contagion, school closures, event cancellations and travel restrictions on workers are starting to hurt tourism, airlines and leisure companies across Europe — as well as investor and business sentiment.
“The one billion dollar question is: how long will it last?” said Jörg Asmussen, a former ECB chief economist who is now head of Germany’s insurance association. “Is it temporary? How many months before a V-shape recovery starts?”
Ms Lagarde is also grappling with the question of what action the bank’s governing council could take.
Unlike the Fed, the ECB has not lifted rates from their post-2008 financial crisis lows. Instead it kept cutting, most recently in September to a record low of minus 0.5 per cent. As Ms Lagarde herself said recently, this has “significantly reduced the scope” to cut rates further.
Central banks may have to become directly involved in providing bridge financing to key firms and sectors, and in pushing banks to do likewise
Adam Slater, Oxford Economics
Policymakers across Europe — including the ECB — “still have lower rates than the US and do not need to follow the Fed necessarily”, said Vítor Constâncio, former vice-president of the ECB. “Some will do it though, despite everyone believing that the effects are quite meagre.”
There is already a growing debate about the adverse effects of keeping interest rates negative for many years and economists even doubt another cut would do much to help with the virus’s immediate impact.
“When you have negative rates, you are effectively targeting bank reserves, you don’t need a rate cut to allow overnight market rates to drift lower temporarily,” said Lena Komileva, chief economist at G+ Economics.
Complicating the picture for Ms Lagarde are the deep divisions in the ECB’s governing council, which blew up into a public spat the last time it cut rates six months ago. Some policymakers strongly oppose further cuts.
On top of this, the response by EU governments to the disruption of the virus has so far been patchy and underwhelming — particularly in comparison with the €200bn spending package co-ordinated by Brussels after the 2008 crisis.
This all puts more pressure on the ECB to take action; financial markets are pricing in a further rate cut to minus 0.6 per cent.
Ms Lagarde, however, has hinted that her focus is on providing extra liquidity to the banking and corporate debt markets. She said in a recent statement that the ECB was “ready to take appropriate and targeted measures” to address the crisis.
A big worry for economists is that the strain on disrupted businesses could lead corporate debt markets, where levels of leverage and overall indebtedness have been rising, to seize up.
One way to address this would be to expand the ECB’s €2.6tn asset purchase programme, which was relaunched last year. The ECB could temporarily increase its size, particularly by buying corporate paper.
Another possibility would be to bulk up the ECB’s existing programme of targeted loans to banks at sub-zero rates on the condition that they use them to fund lending to small businesses. Finally, the ECB could widen the types of collateral it accepts from banks to include more loans to small businesses hit by coronavirus disruption.
“Financial strains that worsen the downturn are a major risk,” said Adam Slater, lead economist at Oxford Economics. “Central banks may have to become directly involved in providing bridge financing to key firms and sectors, and in pushing banks to do likewise.”
He added that this may require a suspension of EU fiscal rules to allow member states to run higher deficits.
For the eurozone economy, which had already slowed to its lowest growth rate for seven years at 1.2 per cent in 2019, coronavirus could hardly have come at a worse time.
The economies of France and Italy both shrank in the final quarter of last year, while Germany’s flatlined. Morgan Stanley forecasts the eurozone will suffer a recession — two consecutive quarters of negative growth — in the first half of this year.
The risk for the ECB — which is expected to cut its own economic forecasts on Thursday — is that its response will be seen as inadequate, leaving Ms Lagarde and her fellow governing council members looking increasingly powerless.
“We acknowledge the risk that the ECB might only respond to the shock in stages, given the lack of economic evidence available and internal divisions,” said Ken Wattret, chief European economist at IHS Markit. “But an adverse market reaction to falling short would force the ECB to take more radical steps subsequently.”
(Source: here)
