Striking contrast between US and Euro Policy response

The consensus view on the economic impact of the Covid pandemic envisages a plunge in economic activity across the global economy in the second quarter of the year, followed by a recovery in the latter part of 2020, with no significant damage to potential growth. This may prove optimistic but also appears  the prevalent view in equity markets, with investors ignoring  data which does point to a very severe hit to output and employment, believing  that short lived. Policy makers have reacted, of course, and we have seen a significant fiscal and monetary response, although that has varied across the globe and the contrast between the US and the Euro area (EA) in that regard is particularly  striking.

On the monetary side the Fed  initially reacted to a scramble for dollar liquidity by pumping trillions of dollars into markets that were effectively seizing up, including the provision of dollars to other central banks across the globe. It then embarked on a broad purchase of assets, ranging far beyond government bonds  and mortgage backed securities,  to include bank loans and even junk rated corporate bonds,  taking the extraordinary step of buying the latter through ETF’s. As a reult the Fed’s balance sheet has grown by over 50% since the turn of the year, currently standing at $6.6 trillion from $4.2 trillion. As a result excess reserves held by commercial banks have doubled in just two months, to $3 trillion, while the money supply (M2) has grown at an annualised 16% pace over the past three months. Monetarists might worry about the implications  for inflation down the line but markets certainly feel it is supportive of asset prices.

Monetary policy has also been supportive in the EA , but the scale of the response is quite different; the ECB’s balance shee has increased too but by only 12%, to €5.3 trillion from €4.7, and the amount of exces liquidity in the system has not greatly changed.  It is also worth noting that interbank rates  have actually risen (3-month euribor rose to -0.16% last week before falling back to -0.22%) implying that all  EA banks are not deemed equal, while it is reported that US banks are pulling back their EA lending.  Of course the ECB is constrained in its response relative to the Fed in that it can provide  short and now longer term loans to banks  but cannot buy unlimited amounts of assets, as its public sector purchases are contrained by the capital key  and issuer limits. It has sought to circumvent the latter with its PEPP scheme, but that is limited to €750bn , at least for now.

On the fiscal side the EU has struggled to find a mechanism to provide support across member states, with the result that each county has sought its own solutions, although the degree of fiscal space available varies greatly. A €540bn package was produced to great fanfare by euro governments, but as with many such announcements the devil is in the detail- in this case €100bn was in the form of employment grants from the European Commission, with the rest in the form of EIB loans and  ESM loans, with the latter unlikely to be taken up. Grants rather than loans became the big issue at the recent EU summit, with headlines emerging about a package amounting to ‘trillions’ but nothing was agreed and it seems that  funds will eventually come out of the EU budget, with the issue of loans versus grants kicked down the road.

In the US the  Federal fiscal response has been quicker and substantially larger, with a series of packages emerging, the largest being €2 trillion. Again one should note that some of this is in the form of loans, albeit guaranteed by the government on attractive terms. That said , the IMF expects the US fiscal deficit to exceed 15% of GDP this year, which is more than double that forecast for the EA. . In any downturn automatic  stabilisers kick in ( tax receipts fall and government transfers rise) so fiscal deficits will increase  anyway in the absence of any discretionary policy action but the difference between the respective US and EA deficits is clearly not just cyclical.

 

ECB -where to from here?

The ECB’s mandate is to deliver price stability, which the Bank itself initially defined as an annual inflation rate below 2%. Clearly there was no thought given to the risks of deflation with such an asymmetric target and the definition was subsequently tweaked to the current ‘below but close to 2%’. Euro area inflation fell below 2% in early 2013 and below 1% a year ago, with the latest ECB staff forecast projecting very low inflation for at least another two years. Moreover , the forecast was predicated on oil prices averaging $86 a barrel next year , which now looks high given that Brent is currently trading under $70.

There are ‘long and variable’ time lags with monetary policy, so one could argue that the current low inflation rate (the flash figure for November was 0.3%) reflects policy decisions made some time ago-remember the ECB actually tightened policy in 2011. Against that backdrop the recent press conference by ECB President Draghi was remarkable in many ways, not least because he had promised ‘immediate action’ on inflation in a speech in the latter part of November.

In the event the only change of note was in the language surrounding an expansion of the ECB’s balance sheet, which had been  ‘expected‘ to reach the level seen in early 2012 but now measures are ‘intended’ to achieve that level. That would entail an increase of about €1,000bn and clearly there is no agreement within the ECB to promote that as a target. Indeed, Draghi stated that there was not unanimity among the 6-member Executive Board on the announced change in wording, limited as it was.

Draghi had previously played down disagreements within the Governing Council but here seemed willing to place them out in the open, emphasising at one point that previous decisions had been taken  by majority. The obvious divisions  on further policy action made for an uncomfortable conference, however, with Draghi having to again indicate the need for more time to assess the situation despite more forecast downgrades and the blatant contradiction between that  approach and his earlier promise of ‘immediate action’

The upshot is that the Governing Council will reassess the situation ‘early next year’  including the size of the balance sheet. That will be affected by the existing bond buying programme (albeit the figure to date is just €22.5bn) and the outcome of the second targeted long term loan operation (the TLTRO). The latter saw a low uptake for the first tranche (€82bn) and there is a wide range of expectations with regard to the one upcoming, while there will be some offsetting downward pressure on the balance sheet via repayment of previous long term lending to the banks.

The euro rallied during the conference, which was attributed to disappointment about a  QE announcement, although that remains  the market’s general expectation. For others, including this writer, it remains less than a certainty that the ECB will eventually buy sovereign debt, and if it does it is not at all clear how much of an impact it will have on economic activity and inflation, leaving aside the impact it has already had on asset prices. A lot of uncertainty then, and one wonders if the next few months will see further resignations from the ECB Council given the fundamental disagreements on the next steps for monetary policy.