Interestingly, President Lagarde, approaching the first anniversary of her appointment, emphasised that the policy "recalibration" will involve all of the ECB’s policy instruments, not just an increase in the size of the pandemic emergency purchase programme (PEPP). This message was presumably intended to highlight the numerous policy choices available (including deeper negative interest rates). It also gives the ECB more flexibility to find the best mix of instruments for December.
The latest data across the Euro area is clearly pointing to a reversal in the tentative recovery seen through the summer. The newly announced lockdowns, while less dramatic than those back in March, are still likely to deal a significant blow to economic momentum throughout Q4 2020 and early 2021. In fact, we believe there is a very high probability that the Euro area economies are going to slip back into recession this winter.
In this regard, the ECB may indeed need to do more in December than increase the size and duration of the PEPP (our expectation is an increase of EUR 750bn, which is above consensus expectation of EUR 500bn). Potential policy actions, in order of likelihood, could include extending targeted longer-term refinancing operations (TLTRO) bank funding and cutting the funding rate more deeply negative; expanding asset purchases to other assets (e.g. bank bonds); and stronger forward guidance on interest rates and asset purchases. Cutting the deposit rate would probably be too controversial, though this option could still be used as a signalling tool, especially in the case of significant EUR strength, depending on the outcome of the US elections.
The next few weeks will be challenging for the ECB as it tries to decide on the best policy action in December as monetary policy effectiveness remains under stress. Apart from assessing the likely impact of the pandemic on the economy, policymakers might also need to react to other developments such as the US elections and Brexit negotiations, depending on their impact on markets and overall financial conditions. This will be a busy and long winter in lockdown with fiscal policy once again becoming the main driver of any rebound as the second wave passes through.