Fra BNP Paribas:

Normalisation on hold: Our central case – below-trend growth and moderately higher core inflation with persistent downside risks – is sufficiently negative to close the window of opportunity of further policy normalisation, in our view.

While we think the ECB will want to keep a high degree of monetary accommodation through measures such as a new TLTRO and changes to forward guidance on rates, the
outlook is unlikely to be bad enough to warrant stronger medicine, such as further rate cuts and/or resurrecting QE.

With scarce ammunition left, the threshold for the latter is high, we think, and would require at least one of two conditions: an economic downturn accompanied by lower inflation and perceived risks of deflation; or a fully-fledged recession. Neither is part of our central case.

At the same time, it will be difficult for the ECB to contemplate further policy normalisation, as the risk would be to precipitate a recession. We believe, therefore, that the ECB will leave its depo rate unchanged at current levels for the foreseeable future.

This leaves us with three questions.
 Will the ECB consider new targeted longer-term refinancing operations?
 Will the ECB change its forward guidance?
 Will the ECB consider a form of interest rate tiering in order to reduce the hit to banks’ net interest income from persistently negative interest rates?

Pros and cons of TLTRO: The ECB certainly looks to be contemplating this option. At October’s press conference, President Mario Draghi said the TLTRO was raised by two
speakers at the Governing Council meeting. This became “some” members in December and “several” in January.

The strongest argument in favour of a new TLTRO is that with around EUR400bn of liquidity expiring in June 2020, not announcing a new one would be equivalent to tightening
monetary conditions. We expect March’s ECB staff projections to estimate this year’s real GDP growth at no higher than 1.4%, compared with 1.7% in the December projections – a material enough downgrade, in our view, to warrant maintaining an unchanged monetary policy stance.

Although the expiry of this tranche is more than a year away, banks’ regulatory framework gives them a strong preference for funding longer than 12 months, so there is a real risk that a proportion of this EUR400bn will be repaid in June 2019.

New liquidity should help banks to meet the net stable funding ratios. Extending forward guidance at a time when the Council is not yet convinced that the weak patch will do lasting damage to inflation convergence would risk ‘wasting a bullet’. As a new TLTRO would avoid that, it might work as a compromise between the hawks and doves – on the one hand, those who have not given up on interest rate normalisation and might still be arguing that there will be a strong rebound and, on the other, those who would want to already postpone normalisation by changing forward guidance.

A new TLTRO might also have a signalling effect by showing that the central bank is indeed not out of ammunition and is ready to deploy some of the instruments in its toolbox to
prevent a further deterioration in the economic outlook. The strongest argument against a new TLTRO, in our view, is that liquidity is and will remain ample.

Banks have long been aware of the end of the TLTROs and there is no clear evidence of impairments in the credit channel to justify such an operation. As Benoît Cœuré stated bluntly in a recent interview, helping banks to meet their liquidity ratios “is not
the business line we are in”.

There is no obvious necessity in terms of lending, either, as the latest ECB Bank Lending Survey reported credit conditions are still permissive, with Italy driving any tightening.
Mr Draghi has cautioned that a TLTRO would not be launched to help particular banks or particular countries. There might be political/communication risk in launching an
operation that would be widely held to benefit Italian banks – and, by extension, the Italian sovereign.

There is also some franchise risk in launching an operation that might have limited take-up – although this risk might be mitigated by making the conditions sufficiently beneficial to
attract enough bids. Fresh TLTRO expected: On balance, we believe the pros outweigh the cons and the ECB will announce a new TLTRO as early as March, at the same time as its new economic projections. The conditions of the operation could be communicated at a later stage (perhaps June?) and would very much depend on the data evolution over the next few onths.

We think the most likely option would be a three-year TLTRO with floating rates, which would allow banks to roll over the previous TLTRO for a new two-year period window, while
leaving the ECB the option to raise rates over the period. Forward guidance: We would argue that another potential instrument, forward guidance, is already working. As Mr
Draghi has explained, forward guidance has two parts: a time-dependent element (which states the ECB won’t raise rates throughout the summer) and a state-dependent one
(according to which the timing of rate hikes is conditional on the inflation outlook).

The markets have reacted to the state-dependent element by pricing out rate hikes anytime soon. Accordingly, we think a meaningful market impact would require a bold change that moves the first possible date for a rate hike considerably later than the current guidance of “at least through the summer of 2019”.

Our expectations are for something more modest, especially as the top policymakers are probably reluctant to tie their successors’ hands so late in their terms (Mr Draghi is due to
step down in November). The ECB might still hope to send out a signal when it eventually shifts its forward guidance to a later date – to, for example “at least until the end of the
year” – but we think this would more or less validate current market expectations.

Although such a change would be unlikely to have a significant market impact, in our view, it would still protect financial conditions from tightening in the event of a
temporary rebound in the economy.