Shoot now and risk firing blanks: Lagarde's Covid-19 dilemma at ECB

Frankfurt

THE first crisis of European Central Bank president Christine Lagarde's four-month tenure will force her to decide this week whether to fire one of the few monetary-policy bullets she has left.

Days after the Federal Reserve slashed interest rates, Ms Lagarde and fellow policymakers must judge if the economic effect of the coronavirus merits cutting the euro area's benchmark from the current minus 0.5 per cent. Plunging global markets on Friday were a reminder that investors are seeking more stimulus.

An ECB reduction of at least 10 basis points on Thursday should satisfy those expectations and add the euro-area central bank to the list of those using rates to shield their economies. But it could also backfire by doing little to address the specific impact of a health emergency, undermining financial stability and reducing policy space the bank might be better off preserving.

Bank economists are split. UBS and Goldman Sachs are among those forecasting a cut, while Bank of America, Morgan Stanley and HSBC expect no change in rates.

Some expect the pace of quantitative easing to be stepped up.

"Even though the ECB doesn't cater or shouldn't cater to financial markets, you have to take into consideration the risk of disappointing markets and triggering a further correction," said Katharina Utermoehl, senior economist for Europe at Allianz in Frankfurt. "A rate cut is not going to help problems in the real economy, so it has to be a part of a more comprehensive package."

Mindful that disruptions to global supply chains and travel are straining cash flows at companies, Ms Lagarde and her 24 Governing Council colleagues are seen delivering measures to support liquidity when they meet. Likely options under consideration include incentives for banks to keep funding virus-hit firms.

Lenders are already making overtures - for instance, Germany's HypoVereinsbank is advertising options to refinance loans or extend repayment deadlines - though they would no doubt welcome ECB support.

Ms Lagarde is also likely to issue another plea for backup from euro-area governments, after previous cries largely fell on deaf ears.

But how to deploy interest rates is sure to be a headache. While Ms Lagarde has pledged to do what's needed, the limited space for monetary policy puts her in a much tighter bind than her international peers. The Fed's target rate is still above one per cent even after last week's reduction of half a percentage point.

The ECB's prevailing limitation is that the longer it pursues its ultra-loose policies of negative rates and bond purchases, the worse the side effects will get. Bank margins could be squeezed so hard that lending dries up, and overvalued asset prices - such as homes - could cause financial instability.

Economists aren't convinced that blunt monetary stimulus is the best strategy anyway. Former ECB vice-president Vitor Constancio weighed in on that topic on Twitter last week.

Ms Lagarde's pledge to deliver "targeted" measures if needed suggests the ECB may adapt its existing programme of long-term loans to financial institutions or plan a new variant of it. The initiative, which has run on and off since 2014, gives banks an incentive to lend to companies and households, and could probably be tweaked to target SMEs.

It may be the most appropriate response - JPMorgan Chase economist Greg Fuzesi has even come up with a model for how it could be designed - but on its own it might not satisfy the investors who Ms Lagarde has said "interpret, misinterpret or overinterpret our actions".

Elsewhere, the Bank of England and the UK government are coordinating complementary measures for maximum impact. The US has agreed on a US$7.8 billion emergency spending bill. In Japan, which also has negative rates, the prime minister has pledged economic measures if needed, and the finance minister has urged financial organisations to provide support for businesses.

The ECB president hasn't yet had that fortune, despite the European Commission warning finance ministers last week that France and Italy are at risk of recession and a prolonged outbreak could lead to a "vicious" spiral of declining markets.

For Nick Kounis, an economist at ABN Amro in Amsterdam, the slowness of fiscal responses is a reason for Ms Lagarde to be decisive now.

"I do believe that the ECB will eventually do whatever it takes," he said. "Looking like you are being dragged kicking and screaming into it doesn't look great. You need to give people more clarity." BLOOMBERG