Monetary policy: The ECB has admitted its limits

It couldn’t have come on a worse day: Christine Lagarde had US president Donald Trump to thank for that.

Her first big test as president of the European Central Bank (ECB) was already an all-but impossible one to pass, and even more so after a new US ban on flights from continental Europe earlier on Thursday had put a big damper on the eurozone’s most important monetary policy meeting in years.

Yet if equity markets are anything to go by, the ECB singularly failed to reinstall confidence, even underperforming the lacklustre market response to the 50-basis-point cut by the Federal Reserve earlier in March.

The continent’s stock exchanges deepened the morning losses that followed the flight ban, marking record falls in the wake of the ECB’s decision to keep rates on hold. Investors had been pricing in a 10bp cut. More worryingly still was the sell-off in Italian government debt, as spreads to German government bonds shot up.

The president of the European Central Bank during a press conference on Thursday 
© European Central Bank 2020

At the moment of a potentially devastating shock to Europe’s economy – originating in Italy – Lagarde, at first glance, did nothing and may even have made the situation worse. She all but admitted the ECB’s strongest monetary tool is useless and that using it could even exacerbate the crisis just as much as leaving it untouched, worsening the market reaction.

From the perspective of some banks and many economists, the ECB might have done almost all it can, short of extending quantitative easing (QE) to equities and bank debt. It kept the rate unchanged, but said it could, hypothetically, keep rates so low and even cut them in the future.

It is also expanding QE by €120 billion and announced new and unprecedently generous terms for its third targeted longer-term refinancing operation (TLTRO III).

“We are not at the reversal rate,” Lagarde told reporters after the decision, explaining that lending data demonstrate negative rates are not yet curtailing credit, as banks have long feared, but rather are still encouraging it.

This raises a problem, though. If she’s so sure of the present truth of that statement, surely the ECB should have cut the rate. The fact it did not suggests that central bankers, at least in Europe, are finally listening to the complaints of the banks – understandably, yet perhaps not entirely correctly.

The risks are definitely tilted to the downside, that’s for sure 

 – Christine Lagarde, ECB

With the ECB’s deposit rate at -50bp, having been negative for more than half a decade, a deeper cut would have laid an even heavier blow to banks’ net interest margins, the most important part of their revenues.

This would have come at a time when they are already shakier due to the likely damage to their revenues and asset quality from the economic downturn – and when they are the most crucial player in ensuring the coronavirus economic downturn is temporary, by keeping credit lines open even while their borrowers’ earnings and debt-service capacity fall.

As Lagarde said, what Europe needs is fiscal stimulus on a far greater scale than measures announced so far. If people have to stay at home, no amount of monetary stimulus will do any good.

The ECB’s biggest fear might rightly be that the crisis leaps from health to the economy, and then a credit crunch, bank funding drought and even deposit runs.

Lagarde flagged the danger of liquidity problems in the banking sector, if things get worse.

“The risks are definitely tilted to the downside, that’s for sure,” she said.

TLTRO III

This is hardly an encouraging statement, but it explains why the ECB also announced additional longer-term refinancing operations, partly to bridge the period until TLTRO III kicks in this June.

The new TLTRO programme, to be sure, is a big gift to Italian banks. They will be able to access three-year funding for 50% of loan books to borrowers affected by the coronavirus, especially small and medium-sized enterprises (SMEs), at 25bp less than the ECB’s own deposit rate.

Italian banks were the biggest users of previous TLTRO programmes. They are also the least capable of managing another rise in non-performing loans (NPLs).

But the biggest gift Italy’s banks could hope for is lower yields on their government’s debt, not least as the mark-to-market benefits immediately boost their capital. What the ECB achieved is the opposite, partly thanks to Lagarde’s misjudged comment that “we are not here to close spreads”.

That comment, coupled with the decision to leave rates on hold, suggests she and her colleagues have been too worried about the banks and not worried enough about the sovereign, in a state that could soon be facing collapse.