ECB: looking for a targeted response

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● Dealing with the second-round risks: Coronavirus is a direct, negative real shock to global supply and demand. Monetary and fiscal policy cannot deal with the disruptions directly; they can merely mitigate effects on confidence, income, wealth and employment. In addition, they can prevent or at least alleviate financial stress that may otherwise result from the shock and try to partly offset the damage to aggregate demand by an offsetting stimulus.

● The Eurozone is different: Although the Eurozone is more affected by the virus than the US, it is far less sensitive to financial market sell-offs. Due to sizeable automatic stabilisers in the Eurozone’s extensive welfare states, employment, disposable incomes and consumer spending in key parts of the Eurozone also react less to real output shocks than in the US. The Eurozone also needs a discretionary policy response, but less so than the US or the UK.

● Fiscal policy first: Supply-chain disruptions, lockdowns and sudden plunges in demand can cause significant liquidity problems for businesses, especially for smaller and medium-sized ones. Policymakers can help heavily affected businesses by offering temporary support including tax credits. They should also activate schemes that subsidise temporary “on-the-job” underemployment along the lines of the German Kurzarbeitergeld.

● Limited room for the ECB: Unlike the Fed, the ECB has limited room to act as its key rates are zero or negative already and it is facing a dearth of investible sovereign bonds under its current rules. Cutting the deposit rate from -0.5% to -0.6% and injecting more liquidity into a system already awash in cash would not make much of a difference. So far, ECB President Christine Lagarde has merely signalled her readiness to take “targeted measures” if necessary.

● ECB aiming for targeted measures: The ECB will almost certainly try to intervene. However, contrary to market expectations, we currently see only a 40% chance for a 10bp cut in the deposit rate on 12 March. The adverse market reaction to yesterday’s panicky-looking Fed move may make the ECB even more reluctant to lower its deposit rate. Instead, we expect the ECB to announce some targeted measures, such as new liquidity injections or re-financing facilities for banks, aimed at keeping liquidity flowing to small and medium-sized businesses. The ECB could also tilt its bonds purchases more towards corporates and offer even more generous long-term refinancing operations for banks. In addition, expect the ECB to emphasise that its state-contingent forward guidance itself provides ongoing major monetary easing.

● Bigger, broader response possible: If and when the coronavirus outbreak worsens significantly and/or the euro continues to appreciate versus the US dollar meaningfully, we would expect the ECB to cut its deposit rate from -0.5% to -0.6%. If so, the ECB would also make its tiering system more generous so that the package can benefit rather than hurt the banking sector. If push comes to shove, the ECB could increase the monthly bond purchases and thus create additional breathing space for corporates and governments. In a worst-case scenario of an escalating financial panic, the ECB might even consider to buy bundles of equities such as exchange traded funds. But that seems highly unlikely for the time being.

Florian Hense

European Economist

+4420 3207 7859

florian.hense@berenberg.com

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