The European Central Bank’s response to the coronavirus (Note)

Usefulness: this article summarizes the policies implemented by the ECB in response to the coronavirus crisis and sheds light on their relevance in a highly unusual context.

Summary:

· The article summarizes the main measures implemented by the ECB in response to the Coronavirus economic crisis, from March to June 2020.

· Although some measures, such as the PEPP (pandemic emergency purchase program), appear similar in form to measures taken by the ECB in the past (such as the PSPP, the public securities purchase program), they differ in substance.

The PEPP enables the ECB to act to ensure medium-term price stability by helping governments take the fiscal measures necessary to maintain supply and demand and by containing risk premiums. The link between these actions and economic stabilization is much more indirect than before.

· The PEPP and other specific monetary programs (TLTRO, PELTRO) enable the ECB to act to ensure medium-term price stability by reducing the risk of a second economic wave. The link between these actions and economic stabilization is also more indirect than before.

The arrival of the coronavirus and the lockdown measures that followed in many countries were, as everyone now knows, not only a social and health challenge for the population, but also a major shock to our economies.

Faced with this unusual shock, central banks have had to adapt their policies. In this series of articles, we review the measures implemented by the European Central Bank (ECB) and the US Federal Reserve (Fed) in response to this unprecedented economic shock. The first part of this series focuses on the ECB’s response to Covid-19. What did the ECB do? Why did it take these measures?

1. Chronology of actions

Let’s start with a timeline of the main actions taken by the ECB, before attempting to shed light on their relevance in responding to current problems:

–On March 12,2020, the Governing Council decided on two main actions at its regular meeting: 1) adjustments to its program of exceptional long-term financing for banks, the cost of which depends on the amount of loans distributed to the economy, known as TLTROs[1], aimed at encouraging banks to keep the credit tap open, 2) an increase in its asset purchase program (the PSPP) by €120 billion.

–On March 18, 2020, shortly before midnight, and following several days of tension over Italian sovereign bond yields in particular, the ECB announced the implementation of an exceptional asset purchase program (sovereign and private assets) worth €750 billion, the PEPP ( Pandemic Emergency Purchase Program) [2].

–On April 7, 2020, the ECB announced a relaxation of collateral acceptance criteria and a 20% reduction in the haircut it normally applies when lending to banks[3].

–On April 22,2020, the ECB announced a change in its collateral eligibility criteria. In particular, assets that met the rating requirements on April 7 will be considered (and evaluated) by the ECB, even if they have been downgraded by rating agencies (making them theoretically ineligible in the absence of this measure)[4].

–On April 30, 2020, the Governing Council took two main decisions: 1) to further reduce the cost of TLTROs for banks that meet the criteria set (up to -1%, i.e., 50 basis points below the deposit facility rate), and 2) to launch new long-term lending operations for banks, called PELTROs ( Pandemic Emergency Long Term Refinancing Operations ), consisting of seven lending operations with a maturity of approximately one year and a cost equal to the refinancing rate (« refi ») minus 25 basis points (currently -0.5%).

–On June 4, 2020, the Governing Council decided to increase the PEPP envelope by €600 billion, bringing the program to €1.350 trillion. The ECB’s target end date for the PEPP was extended to June 2021.

Other strong measures were announced, such as new long-term loans to banks (LTROs) on March 12[6] and the extension of the corporate bond purchase program (CSPP) to other asset classes.

2. The relevance of the ECB’s policies

Let’s start with one of the ECB’s two flagship measures announced on March 12: the extension of the PSPP. This is a direct continuation of what had been done before. It could therefore be justified as being linked to the ECB’s primary objective of maintaining price stability. The channel leading to this objective is the same as that used previously: lowering long-term interest rates in order to support demand from economic agents (consumption and investment). Even if, in this context of uncertainty, we can of course doubt the effectiveness of this channel compared to its past effectiveness. That is not really the issue: if we had to choose, we could agree with the ECB that doing more was in any case certainly preferable to the status quo.

As for the other measures taken by the ECB since March 12, they can be seen, as with the PSPP, as aimed at stabilizing demand in orderto ultimately ensure price stability. But in a much less direct way than has been the case in recent years. They can also be seen as part of a much broader framework than the one that has guided its decisions in recent years.

In particular, the PEPP can be seen as direct (and temporary) support for countries whose fiscal sustainability is likely to be severely questioned. Governments are currently facing very high levels of expenditure. As Olivier Blanchard explained in a recent discussion, the danger for many governments is that their borrowing rates will rise. By ensuring that the central bank buys back public debt, the PEPP helps to limit the rise in borrowing rates. In doing so, the ECB:

(1) helps governments to make the current expenditure necessary to prevent demand from falling further and the productive fabric from collapsing;

(2) officially ensures that the transmission of its monetary policy is not affected (an increase in perceived risk could cause interest rates to rise in some countries).

The first part of this action can be seen as indirect support for demand, but also as an action related to other parts of the ECB’s mandate[8]. Or quite simply as a policy mix: government action is supported by their central bank in this exceptional context. It is perhaps this different essence that justified different arrangements for the PEPP, such as the inclusion of Greece.

The ECB is also taking action to reduce the risk of a « second economic wave. » Its actions for banks are directly related to this. To avoid this « second wave, » it is necessary to prevent the crisis in the real economy from 1) spiraling out of control (with business bankruptcies, higher unemployment, and therefore a sharp drop in demand, etc.) 2) migrates to the financial sphere (with problems of household and corporate solvency, leading to bank failures, etc.).[9] The ECB’s actions can be seen in this light of avoiding a second wave:

– TLTROs , like PELTROs, provide indirect support to businesses (and therefore supply) and households, in particular by reducing the risk of credit drying up. If credit were to dry up further, this would increase the cost of corporate bankruptcies, and therefore unemployment, and therefore demand. The economy would once again be severely affected for several years.

– TLTROs , like PELTROs, also provide support to banks when there are doubts about their financial situation, by providing them with significant and stable financing during this period. They thus help to reduce the risk of liquidity and financial crises.

– Measures to broaden collateral eligibility and reduce haircuts help limit the risk of fire sales and liquidity crises, and indirectly support the supply of credit to businesses.

TLTROs, like the broadening of collateral eligibility criteria, therefore indirectly support supply with a view to providing longer-term support to the economy. PELTROs may be aimed more at limiting the risk of bank liquidity problems.

The latest measure (broadening collateral eligibility and lowering haircuts) makes risk « cheaper » and therefore more attractive for banks, and thus for the financial system. This comes at the cost, of course, of greater financial risk for the central bank, and ultimately for taxpayers. Markus Brunnermeier said it recently: in this period, governments and their central banks must, paradoxically, take more risks if they want to limit the materialization of risks. This is partly what the ECB is currently doing.

Conclusion

The ECB, like many other central banks, has had to take strong and unusual measures to respond to this unusual shock linked to the coronavirus epidemic. While some of these measures resemble those taken in previous years in form, they differ in substance. For example, the aim of the PEPP is not directly to lower long-term rates, as was the case with the recent QE program, but to prevent an increase in risk premiums and to help governments take the necessary measures to maintain supply and demand. The PEPP and PELTRO should enable the ECB to reduce the risk of a second economic wave. The link between these actions and economic stabilization is more indirect than before.

For more information on the PEPP, see this FAQ on the ECB website: https://www.ecb.europa.eu/mopo/implement/pepp/html/pepp-qa.en.html