ECB View: Case for stimulus is clear, but action is likely to wait until December – The ECB Governing Council meets this week to discuss monetary policy. The case for further monetary stimulus is already strong. Rather than continuing to grow rapidly in the fourth quarter as the ECB expected, the eurozone economy looks to be back in modest contraction mode.

The risks are skewed towards a deeper contraction going forward given that there is no end in sight to the second wave of the virus, which could also trigger more severe restrictions. Meanwhile, once again core inflation is turning out even weaker that the central bank’s projections and with spare capacity elevated, underlying inflationary pressures will weaken over the medium term.

Although pre-emptive action can be more powerful than falling ‘behind the curve’ in terms of shaping expectations in financial markets, the ECB does look set to wait. There appear to be differing views in the Governing Council on whether to continue with a wait and see approach.

Executive Board member Fabio Panetta, the Governor of the central bank of Spain Pablo Hernández de Cos, the Governor of the central bank of Finland Olli Rehn and to a lesser extent Chief Economist Philip Lane have made the case for further stimulus. On the other hand, ECB Vice President  Luis de Guindos, Bundesbank President Jens Weidmann, DNB President Klaas Knot and the Governor of the Banque de France François Villeroy have made the case for waiting. ECB President Lagarde appears to want to build a strong consensus before taking action.

In addition, even though the ECB likely already judges that further stimulus is necessary, it may need more information to decide on the shape and size of that stimulus. The Governing Council will have the new macro staff projections in December, while it will also be clearer how the second wave of the virus and government restrictions are evolving.

Ultimately, we think the ECB will hold off from new stimulus this week but we expect the Governing Council to signal strongly that it is very likely that stimulus will be announced in December. In the past, the strongest signal has been that officials have been tasked with assessing the design of measures (the Committees being put to work).

What will further ECB stimulus look like? We think that asset purchases under the PEPP will still very much be the central plank of the package. The ECB judges that QE has had the biggest impact on growth and inflation relative to its other policy tools.

In addition, the PEPP has much more flexibility than the APP. Although the APP will eventually need to be stepped up and to take over from the PEPP, it might be too early to make this transition. The Governing Council can easily make the case that it is still dealing from the fall-out from the pandemic, which is still ongoing, so the use of the PEPP is justified. We expect the PEPP to be increased by EUR 500bn.

Meanwhile, the ECB could decide on further measures to support banks. The TLTRO conditions could be further eased, while the TLTRO rate could be cut further. In addition, the ECB may well decide to increase the multiplier for the calculation of the allowance of excess reserves that banks can hold free of charge.

An increase in the tiering system ratio could modestly reduce the burden of direct costs to banks from negative interest rates. With excess liquidity surging and interbank rates having fallen sharply, the case for this move is strong.

Finally, we do not expect a reduction in the deposit rate. Although the ECB has kept the option of a cut in the deposit rate open, the Governing Council has refrained from using it.

ECB Executive Board member Isabel Schnabel explained in April that ‘a further cut in our main policy rate – the deposit facility rate – would have been unlikely to support sentiment and market functioning at a time when banks’ profitability was already expected to come under additional pressure due to the crisis’. It seems that a deposit rate cut would only be considered seriously as an option in the case of an ongoing sharp appreciation of the euro. However, the euro’s upward trend has fizzled out over recent weeks.