When is a crisis no longer a crisis? A dilemma for the ECB

Like the U.S Federal Reserve and other major central banks around the world, the European Central Bank has thrown unprecedented volumes of emergency stimulus at the economy to support businesses and households through the pandemic.

Now, as activity gains pace, it must decide when to start rolling back that support. Acting too quickly would risk snuffing out the recovery while moving too late could lead to overheating and leave governments complacent about already high debt levels.

The following examines the key issues in the debate and the sticking points that will play out between the various camps in the 25-member Governing Council in the weeks and months to come.

WHAT IS A CRISIS?

The ECB’s 1.85 trillion euro emergency asset purchase scheme will continue until the “crisis phase” of the pandemic is over — a deliberately vague, ambiguous formulation that gives the bank plenty of flexibility and room for debate.

For German Bundesbank President Jens Weidmann, among the euro zone central bank’s most conservative policymakers, the crisis is over once the economy is back to its pre-pandemic size, now expected in the first quarter of next year.

At the opposite end of the spectrum, ECB board member Fabio Panetta says that the bank should only retreat once inflation and inflation expectations move back into line with the bank’s target.

Then there are policymakers in the middle. Some argue that the crisis is over when the economy has made up the two years of lost ground while others say that the labour market, which traditionally lags any rebound, should be a key measure.

Investors currently expect the Pandemic Emergency Purchase Programme (PEPP) to end next March, but ECB President Christine Lagarde has yet to send any strong signals about this date.

REVIEW

Complicating the whole debate, the ECB is now finalising the conclusions of its 18-month strategy review, which is likely to redefine the inflation target and may set some secondary objectives.

The decision when and how to wind down emergency stimulus is almost certain to come only after the review is done, so some of the criteria to be applied in the discussion have not yet even been defined.

FLEXIBILITY

Flexibility appears to be a key sticking point.

ECB bond purchases are normally bound by a whole set of rules, many of which were tossed aside during the pandemic to give the ECB the ability to react to rapidly changing market conditions.

These rules, among others, stipulate that bond buys should be in proportion to the size of each country’s economy, not the size of its national debt, and that the ECB should buy a pre-determined amount of debt during a well-defined period.

It should also buy only investment-grade bonds and must not own more than one-third of any country’s debt.

These rules make it more difficult to help heavily indebted countries like Italy and Spain or to buy bonds of Greece, whose debt is still rated “junk”.

Policy hawks say exceptional flexibility is only for crises while doves say these rules need to be maintained.

The debate also raises a legal issue.

The ECB’s non-emergency bond buys have already been challenged several times in German and European courts and the European Court of Justice cleared those schemes precisely because strict limits were placed on the intervention.

Any changes to those limits are likely to land the ECB back in court.

Signalling a potential compromise, ECB board member Isabel Schnabel said the bank “cannot simply transfer the full flexibility” of the emergency scheme, leaving the door open to maintain some but not all of that flexibility.

RAMP UP?

When the emergency ends, the ECB will still be undershooting its inflation target, so stimulus must continue. But the extent of this support will be a key debate.

Several policymakers, including French central bank chief Francois Villeroy de Galhau argued that the ECB should shift its emphasis to its long-established, more restrictive Asset Purchase Programme, now running at 20 billion euros a month.

But markets are not yet pricing any increase in those purchases even after the emergency buys end, and conservatives, like Austria’s Robert Holzmann, say these expectations are about right.

The problem is that government and corporate debt issuance is likely to stay elevated next year, so reverting to pre-crisis stimulus levels would mean a retreat by the ECB and a rise in borrowing costs.

TAPERING

There should be no “cliff effect” when ECB support is clawed back. But as March approaches, the kind of gradual retreat advocated by Weidmann would mean the ECB having to start reducing purchases as soon as the fourth quarter.

Such tapering would push up borrowing costs, however.

The ECB’s policy doves say the economy is just not ready for that, as governments will exit the crisis with elevated debt levels and even relatively small rises in borrowing costs would impact public finances.