The ECB increased its asset purchase envelope under the PEPP by EUR 600bn, taking the size of the programme to EUR 1350bn. This was higher than the consensus estimate of economists (EUR 500bn), but below our own base case (EUR 750bn). The horizon for the purchases was extended to at least the end of June 2021 (from the end of this year previously). Meanwhile, the ECB communicated for the first time that the maturing principal payments from securities purchased under the PEPP will be reinvested. Reinvestments will continue until at least the end of 2022. The extension of the horizon of the PEPP and the decision to reinvest the proceeds of maturing securities under the PEPP were in line with our base case. No other policy decisions were made (for policy decisions see here).
In explaining the decision, ECB President Lagarde pointed to the deterioration in the inflation outlook as well as the need to ease financial conditions. She noted that the Governing Council was unanimous in the decision to step up monetary stimulus, while there was also broad consensus on the size of the increase in the PEPP. The decision to conduct PEPP reinvestments reflected the possibility of a ‘very protracted recovery phase’(for ECB introductory statement see here though the Q&A transcript will not be added until tomorrow).
Further PEPP increase later this year – We judge that a further increase in the PEPP envelope will likely follow later this year. This reflects the deep recession in the economy and the significant disinflation it will trigger over coming years. Indeed, the risks of a sustained period of modest deflation are now significant. Meanwhile, we also expect further increases in government bond supply this year, which could result in tighter financial conditions (see below).
On inflation, we judge that the ECB has a remarkably optimistic outlook, despite major downward revisions (see here). It expects headline inflation to be at 1.3% in 2022 (was 1.6% in March), which represents a very benign outcome given the rise in spare capacity we are likely to see, not least in the labour market where unemployment will probably surge. Indeed, the ECB expects core inflation to be broadly stable during its forecasting horizon (at 0.8% in 2020, 0.7% in 2021 and 0.9% in 2021). This would be a remarkable outcome. Following the financial crisis, core inflation fell by around a percentage point and then saw a period of sideways movement that lasted essentially all the way up to the Covid-19 crisis. In contrast to the ECB, we expect core inflation to fall to levels close to zero by the end of next year.
Part of the ECB’s optimism on inflation is bound up to a relatively optimistic outlook as far as the economic recovery is concerned. Although we think the ECB is right to judge that there will be a sensational bounce in GDP in Q3, its projections beyond that look rather buoyant. In particular in the four quarters from Q4 of this year onwards, the ECB expects economic growth to average 1.5% qoq. The ECB recognised this in its statement, noting that ‘the Governing Council sees the balance of risks around the baseline projection to the downside’.
Another reason to expect a further step up in purchases is the government bond supply outlook and the ECB’s need to prevent financial conditions from tightening. We estimate additional corona-shock related government funding needs for this year of around EUR 1050bn. More is likely to come on top of that, given the second German fiscal stimulus package (EUR 130bn) and discussions in the same direction from other member states. The PEPP is still not of sufficient size to mop up this year’s supply (given that not all purchases are government bonds) as well as the still large bond supply that will come to the market next year.
The ECB maintains an easing bias despite today’s decisions. The Governing Council asserted that ‘it continues to stand ready to adjust all of its instruments, as appropriate, to ensure that inflation moves towards its aim in a sustained manner, in line with its commitment to symmetry’. Overall, we think a further increase in the PEPP is on the cards, most likely in September.