ECB Preview: Lagarde expected to go again to the PEPP well

New economic forecasts

In April, the ECB suggested that the outlook for the eurozone economy came in the shape of three possible scenarios and could shrink by between five and twelve per cent this year, depending on the success of the coronavirus containment measures. However, last week President Lagarde commented that the long-awaited new staff macroeconomic projections were likely to lie in between the medium and severe scenarios. For comparison, the European Commission had the economy contracting by 7.7% this year and we know now that the stricter the lockdowns, the bigger hit to the economy. What does seem probable is that the ECB will highlight strongly the uncertainty surrounding the forecasts going forward.

Inflation forecasts will be especially interesting as the latest medium-term projections in March showed the ECB still expected a gradual acceleration in prices. Supply distortions and weaker market competition may have supported this view but increasing unemployment and the widening output gap should see sizeable downward revisions.

Increase in PEPP size needed

The key question for Lagarde will be how much the ECB should increase its bond-buying programme or Pandemic Emergency Purchases Programme (PEPP), as it is likely to be exhausted by October at the current rate of use. As widely expected, the bank front-loaded its purchases to contain volatility and financial fragmentation in certain euro area countries. This has in fact continued longer than forecast so the markets expect Lagarde to address this in order to avoid tightening financial conditions and revisiting the levels from mid-March.

Does the still relatively new President want to encourage unwarranted speculation in the markets if there is no increase to the PEPP and it gets close to being used up? It will be a shock if Lagarde doesn’t play to the narrative of a heightening alertness and readiness to act, especially after her initial faux pas in her first press conference.

No impact from the German Court ruling, backing for the Recovery Fund

Complicating issues is the May ruling from the German constitutional court that effectively limits the participation of the Bundesbank in some ECB QE programmes. The court did not actually rule on PEPP, only on the normal asset purchase programme (APP) which has small monthly volumes of roughly €20bn and of which only German government bonds are affected. Being the statesperson that she is, Lagarde will probably find a way to keep open German demands, but without harming the ECB’s independence or fuelling the conflict. As for the proposed EU Recovery Fund, the ECB will welcome the ambitions of the European Commission while at the same time highlighting the risk of diverging trends within the currency union.

From the most recent comments from ECB members, it seems the bank is now in pre-emptive easing mode with the goal of preventing financial fragmentation. With increased confidence in the global economy, the ECB should step up and deliver more, to further cement the removal of any macro tail risk. Expectant markets and renewed optimism over the ‘next generation EU’ has pushed the euro out of its recent range with spot now targeting the March highs.