10 September 2020

The ECB Is Celebrating the European Recovery Fund … While Closely Monitoring the Exchange Rate

By Andreas Billmeier, PhD

In today’s meeting, the European Central Bank’s (ECB) Governing Council (GC) left all major policy levers unchanged and reaffirmed its commitment to ample monetary stimulus. In addition, ECB President Christine Lagarde presented new macro forecasts that take into account the slightly better-than-expected economic rebound over the last few months, but which also continue to show a worryingly low headline inflation forecast of 1.3% for 2022.

ECB Chief Economist Philip Lane’s pointed exchange rate comments in the run-up to this meeting were echoed numerous times during the press conference. Most strikingly, it was early on in the press conference when without prompting Lagarde expanded on the policy statement, saying that the ECB would carefully assess incoming information, including that which relates to the exchange rate. The topic was picked up repeatedly during the press conference, and Lagarde underlined that the appreciation of the euro had been discussed extensively in the GC and had indeed made its way into the introductory statement. This reflects the fact that currency appreciation is a major factor behind the current negative pressures on inflation. Aside from describing the standard notion that the exchange rate is not a target but matters because of its impact on inflation, Lagarde shied away from providing any further insights. In particular, Lagarde refrained from characterizing the exchange rate impact further in quantitative terms, nor did she clarify how broadly shared this concern was among the members of the GC.

As mentioned, Lagarde also provided an update of the June macroeconomic projections in three dimensions. First, she presented revisions to the growth and inflation outlook that were in principle minor except for a 70-bp upside revision to 2020 growth (now -8.0% after showing -8.7% in the June baseline, taking into account a better-than-expected rebound so far), and a slightly higher headline inflation rate for 2021, as well as higher core inflation for 2021 and 2022. Second, Lagarde explained away the negative inflation print in August and stressed that disinflationary risks over the medium term have receded even though growth risks are still to the downside.

Third, Lagarde confirmed that the projections largely do not incorporate the sizeable fiscal measures taken in July in the context of the Next Generation EU (NGEU) recovery fund, presumably due to a lack of specificity. This implies a further upside in the December round compared to current projections, as national government priorities will have to be reflected in 2021 budgets by then. Lagarde went as far as using the word “celebrate” to describe the ECB’s view of those fiscal measures—a clear indication of how appreciative she is of the level of coordination between fiscal and monetary policymaking.

Discussing current policy instruments, Lagarde voiced her view that the Pandemic Emergency Purchase Programme (PEPP) would be fully used, and noted that an extension or expansion of the program had not been discussed. She elaborated that the PEPP would also be the right instrument to purchase bonds to be issued by the European Commission in the NGEU context. Moreover, in response to a specific question on policy rates, she noted, unsurprisingly, that the ECB is determined to use all policy tools when appropriate.

Lagarde also volunteered detailed information on the strategic review, outlining the 10 distinct work and research streams that are now getting back into full swing. The first appointment, later this month, will deal with inflation measurement, presumably touching on the tricky topic of whether and to what extent asset prices should be contained in measures of consumer inflation.

Our View

We think that today’s ECB press conference served as an interim step toward more clarity on a number of fronts. First, December projections will allow a fuller picture of the growth outlook for Europe. Second, the PEPP is the central piece of current ECB policymaking—the ECB is happy with the PEPP’s efficiency and efficacy and will continue to use it extensively. Third, rate cuts are off the table under almost all circumstances, including in response to further euro appreciation as a reinvigorated PEPP can serve to influence the monetary stance. Fourth, we think Lagarde may have left the door ajar to an extension of PEPP—going forward, it could be viewed as less of an instrument to battle fragmentation but more as a response to EU borrowing and possibly further euro appreciation. Finally, the strategic review is now back in full swing, indicating that the ECB has shifted out of acute crisis mode. And we believe the appreciation of the euro has a bit further to run before it will put the ECB back into crisis mode.