ECB super-sizes asset purchases as deflation fears return

The European Central Bank (ECB) has announced that it will expand and extend its newest asset purchase programme (APP) known as the pandemic emergency purchase programme (PEPP).

The PEPP will from now purchase an additional €600bn, taking the total size of the programme to €1,350bn, and will be extended to at least the end of June 2021 (previously end of December 2020). This is in addition to the €120bn one-off increase in the regular APP, and the ongoing €20bn per month purchases under the regular APP.

The increase in quantitative easing (QE) took markets by surprise, leading to a significant rally in government bonds (higher prices, lower yields), especially in peripheral markets like Italy and Spain. Equity markets also rallied initially, but soon fell back below to the levels from the time of the announcement.

The ECB published its latest staff projections, where it downgraded its GDP growth forecast to -8.7% for 2020, before a 5.2% rebound in 2021 and 3.3% in 2022. The inflation forecast was also downgraded to 0.3% in 2020, 0.8% in 2021 and 1.3% in 2022.

Compared to the Schroders growth forecast of -6.1% for 2020 and 4.6% for 2021, the ECB is much more pessimistic for this year and next.

During the ECB press conference, president Christine Lagarde painted a very negative picture, and was at pains to highlights the poor inflation outlook and the importance of returning inflation to the pre-Covid19 path. Though Lagarde dismissed questions over the challenge from the German Constitutional Court, the emphasis on deflation risk may well have been in response to the Court’s ruling that the ECB had not justified the increase in purchases at the end of 2020. We note that there was almost no mention of deflation risk when the PEPP was originally announced, but this has crept in to the ECB communication this month.

It has become apparent that the ECB’s QE programmes are now being used to finance governments, with a bias to helping the member states that are being punished by markets for having poor debt dynamics.

As Lagarde said: “The combination of the fiscal policy and the monetary policy, which clearly at the moment as it is developing are supplementing each other, are working hand in hand, are aligned with similar objectives…”.

As a result, there is a good chance that the ECB expands and extends its programmes further at a later date, as it becomes clear that the public finances of Greece and Italy have become totally unsustainable.