First big test for Lagarde

Liquidity focus to resolve ECB dilemma

Christine Lagarde has a chance of surmounting her first big monetary test and enhancing her reputation for coolheaded professionalism by heading off further across-the board European Central Bank easing to counter corona virus-induced threats.

If the ECB president handles the dilemma adroitly, and barring any further substantive worsening, Lagarde, who took over from Mario Draghi on 1 November, could mark a decisive change compared with her predecessor.

A strong body of opinion on the 25-member governing council, gathering on 12 March, favours crisis-fighting measures focused on liquidity for hard-hit banks and economic sectors, which could involve temporary forbearance for companies hit by severed supply chains. Such steps are regarded as more plausible and measured alternatives to further cuts in the ECB’s negative interest rates or fresh increases in monthly bond purchases.

Lagarde has won plaudits from some council members for more sensitive management compared with Draghi, seen frequently as pre-empting collective decisions through go-it-alone statements. She has started to quell rifts sparked by the previous Draghi-inspired 12 September easing measures, opposed by a significant council minority.

The vocal minority on the council intrinsically against further generalised easing expects a lively debate on 12 March. This will be a major challenge for Lagarde’s more collegiate style and her political antennae in dealing with governments. Opponents of further widespread credit largesse emphasise central banks’ limited capacity to deal with supply-side shocks. They say the ECB should focus on adjusting its targeted longer-term refinancing operations, offering banks long-term funding at attractive conditions. These council members believe that over-hasty central bank steps could let governments off the hook over necessary fiscal expansion. Eurogroup President Mário Centeno said on Wednesday euro area finance ministers are ‘ready to take further policy action’ including fiscal measures. The IMF has announced a $50bn facility for affected countries.

Lagarde said on 2 March, ‘We stand ready to take appropriate and targeted measures, as necessary and commensurate with the underlying risks.’ She has faced criticism of an allegedly laggard response, reviving complaints about the ECB’s initially slow reaction to the 2008 financial crisis, especially much-maligned interest rate increases in 2008 and 2011. Following new cuts this week, the world’s average policy rate for 38 central is at an all-time low.

However supporters of a more calibrated ECB strategy show some Schadenfreude about the initially negative financial market reaction to the US Federal Reserve’s 0.5 percentage points emergency interest rate cut on 3 March. They say the ECB now has a chance of excelling the Fed in communicating with markets. The Fed has a much greater capability for action in view of positive federal funds rates. If the ECB were to cut further into negative territory, that would spark intense opposition in many countries. The sole factor that would sway hawkish council members to back cuts in negative rates would be appreciation of the euro towards $1.15-$1.20. However the present rate around $1.12 looks manageable.

Despite travel restrictions, the ECB is planning a physical meeting in Frankfurt next week. Council members worried about infection will take part by telephone. Those with strong views will have to turn up in person.

Opponents of fresh generalised measures point out that the ECB’s minus 0.5% deposit rate is producing rising negative effects on pensions systems, savers and banks. Further increases in the €20bn a month bond purchase would raise the threat of breaching government bond purchase limits seen as non-negotiable by creditor countries. However there may be room for flexibility in temporarily focusing ECB bond purchases on hard-hit countries such as Italy. This would be under a ‘flexible, yield-contingent approach’ studied in 2016. Central banks would suspend purchases of bonds from countries where yields had fallen below negative interest rate limits.

The dilemma for the ECB has been long in the making. At a Bundesbank conference in Frankfurt in January 2018, Lagarde, then International Monetary Fund managing director, looked on approvingly as Benoît Cœuré, then an ECB board member, warned that Germany would have to step up risk-sharing to forestall risks of more extraordinary ECB monetary action at the next crisis. Cœuré, now at the Bank for International Settlements, said: ‘The more able the euro zone is to absorb shocks, the less you will have to rely on the ECB’ – words that have a prophetic ring.

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