The European Central Bank (ECB) is in a difficult position, with financial markets pricing in a near 100 percent probability of a 10 basis point cut in the already negative −0.5 percent deposit rate on bank reserves when the ECB's Governing Council meets March 12. Markets recognize the relative impotence of monetary policy in responding to the COVID-19 outbreak, which was initially a supply-driven shock that is now morphing into slack demand and the need for decisive government responses to the public health crisis. With the exception of Italy and the announcement of new investment in Germany, however, little is being done and markets expect a central bank independent of politics to step up and act as the "only game in town."
Expectations
It's worth recalling that when the euro faced an existential crisis in July 2012 from the euro area sovereign debt crisis, then-ECB President Mario Draghi declared, "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough." With much of Europe in a COVID-19 panic, expectations are for policymakers to draw a similar line in the sand. Unfortunately, in the absence of a strong coordinated fiscal response, monetary policy has only a small role to play and expectations are likely to be disappointed, especially if action is limited to technical means to provide liquidity.
The ECB will certainly unveil revised forecasts for euro area growth and inflation in 2020-2021 at the March 12 meeting, with the biggest revisions coming for the first half of 2020. Data released on March 10 for the 19 European Union countries that use the euro show fourth-quarter 2019 GDP growth of 0.1 percent. That's somewhat distorted, however, by Ireland, which continues to count offshore exports from Irish-based multinationals as part of its GDP. Much of the euro area might already be in or near recession and falling oil prices add to deflationary fears.
The ECB is in its blackout, no-comment period that precedes policy-setting meetings of the Governing Council, which has been in effect since before COVID-19 became prevalent in Europe. So, it's hard to know what key policymakers are now thinking. Nonetheless, previous positions suggest the direction debate will likely take.
Options
The most contentious debate will be over whether and by how much to cut the deposit rate. The ECB prides itself on not responding to market pressures, but even the most hawkish Governing Council members are unlikely to want to risk further market turmoil solely to make an ideological point. The predicted 10 basis point cut will probably happen, but does little in a practical sense and adds to financial stresses on banks.
The most significant action and probably the overwhelming preference of policymakers is to provide additional liquidity for banks already suffering from compressed profit margins caused by negative interest rates, which will make some proposed government ideas to support COVID-19 recovery, such as mortgage forbearance, more difficult. That could also make added credit available to help small and medium-sized companies that could be having cash flow problems. In the U.S. Federal Reserve's case, it has stepped up repurchase operations in money markets that do not necessarily affect the price of credit but increase its availability. That's less visible and splashy than interest rate cuts. At already low or negative interest rates, however, it keeps credit flowing as the central bank is the lender of last resort and provides more tangible support to financial systems reeling from the effects of COVID-19.
Most likely for the ECB is a revived program of targeted long-term refinancing operations (TLTROs) in which it provides incentives for banks to lend at low-interest rates to cash-strapped companies. The ECB previously had four TLTROs in 2016-2017 that provided reduced rate loan facilities for banks provided the proceeds were on-lent to companies in the real economy. That would minimize further financial stresses from negative interest rates to which policymakers are becoming sensitized and help companies get back on their feet after the COVID-19 crisis ends.
The ECB probably will also discuss increasing the size of its quantitative easing, but it is running into self-imposed constraints that limit purchases of individual sovereign bonds. Increases in the country limits or more targeted quantitative easing could follow, but likely not until after the German Constitutional Court rules on the current program. An affirmative ruling would make it easier for the ECB to engage in what are, in reality, quasi-fiscal operations that finance government budget deficits now expressly prohibited by the ECB's founding treaties. That would overcome some of the limitations of a monetary union without a fiscal union.
Whether technical-oriented action by the ECB will be enough to soothe financial markets and support the real economy won't be known until after the March 12 meeting. At any rate, those will stop well short of another "whatever it takes" moment. What's really needed is support to aggregate demand from government fiscal stimulus.
