ECB: Mind the gap

8 June 2020

The ECB sent a strong signal to the markets following its meeting on June 4 by extending both the size and duration of the PEPP. Evidence that the consequences of the Covid19 pandemic will be long lasting encouraged the Governing Council to emphasise its commitment to support the economy. In this Macro Flash Note, GianLuigi Mandruzzato looks at the monetary policy implications of the ECB's new macroeconomic projections against the backdrop of last week’s decision. The conclusion is that QE and negative rates will remain in place for several more years. 

Only two months after its launch, the ECB’s Governing Council increased the size of the Pandemic Emergency Purchase Programme (PEPP) by EUR600bn to EUR1350bn and extended its duration by six months until at least June 2021. It will also reinvest maturing bonds purchased under the PEPP until at least the end of 20221.  Three reasons are behind the additional measures:

  1. The worsening macroeconomic environment;
  2. The tightening of financial conditions.
  3. The German Constitutional Court’s recent decision regarding ECB asset purchases. 

The ECB's new macroeconomic projections 

Compared to three months ago, ECB staff macroeconomic projections were revised down sharply for both GDP growth and inflation.

The new baseline sees a drop in GDP of 8.7% in 2020 followed by a partial recovery in 2021 (5.2%) and 2022 (3.3%)2.  Hence, by the end of 2022 euro area GDP would still be below the end 2019 level under these assumptions (see Chart 1). More importantly, based on the EU Commission's estimates of potential GDP, the output gap in 2022 would be around 3%, close to the troughs seen after Lehman Brothers’ collapse and the euro area debt crisis. 

Chart 1. GDP and output gap

Source: ECB, EU Commission, Refinitiv and EFGAM calculations.

Reflecting weak demand and low capacity utilisation rates, the inflation rate projections are also lower than three months ago. In the baseline, inflation will be 0.3% in 2020, 0.8% in 2021 and 1.3% in 20223.  In the fourth quarter of 2022, the last period covered by the ECB's projections, the inflation rate is forecast to be 1.4%, suggesting that average inflation will stay below the ECB’s objective also in 2023.

If this turns out to be the case, the euro area inflation rate would have remained for 11 consecutive years below the ECB's definition of price stability of inflation "below, but close to, 2% over the medium term". President Lagarde pointed out that the Governing Council interprets the inflation objective as symmetric, although it has not exactly defined what that means in practice.

One interpretation is that the central bank aims to compensate any shortfall in inflation with a period of inflation above the medium-term target to make sure that, eventually, the level of consumer prices converges to that consistent with the definition of price stability. A similar interpretation sees the central bank ready, and possibly willing, to accept an above target inflation rate after a period of low inflation without reacting immediately, in recognition of the fact it cannot perfectly control prices and also acknowledging the statistical uncertainties in estimating the inflation rate.

Chart 2. Eurozone price level and ECB's aim

Source: ECB, Refinitiv and EFGAM calculations.

HICP: Harmonised Index of Consumer Prices, January 1999 = 100.

According to the latest ECB macroeconomic projections, by the end of 2022 the gap between the price level consistent with the ECB's inflation objective, measured as an annual inflation rate of 1.9%, and that measured by Eurostat would rise to over 7% (see Chart 2). Whatever the interpretation of symmetry embraced by the Governing Council, this clearly suggests the ECB’s monetary policy will not be tightened until well after the end of the period covered by the ECB’s latest macroeconomic projections.

However, markets are not fully pricing in this scenario. 3-month Euribor rates implicit in futures contracts anticipate a tightening of monetary policy in the first half of 2023 (see Chart 3). 

Chart 3. Euro area 3-month interbank rate

Source: Refinitiv and EFGAM calculations. Data as at June 5th 2020.

The PEPP and financial fragmentation

As stressed by President Lagarde during the press conference, the Governing Council is determined to ensure the transmission of monetary policy to all sectors and jurisdictions of the euro area to fulfil its price stability mandate. Following the press conference, ECB Chief Economist Lane explained that despite the results achieved by the PEPP since its launch in March, financial conditions, measured by government bond spreads, remain tighter than before the pandemic (see Chart 4)4.  This is obviously contrary to the ECB's objective and justifies further expansionary measures.

Chart 4. 10-year government bond spreads vs Germany

Source: Refinitiv and EFGAM calculations. Data as at June 5th 2020.

The Governing Council considers that the flexibility of the PEPP currently makes it the most appropriate instrument to both adjust the monetary policy stance and to ensure its transmission to the economy. PEPP flexibility is mainly associated with the possibility purchasing government bonds across euro area countries whilst deviating from the ECB’s capital key. That flexibility is not permitted under the Public Sector Purchase Programme (PSPP). This allows the ECB to intervene where it is most needed. 

The break-down of ECB purchases up to the end of May reflects this. Countries such as Italy and Spain, whose yields had risen strongly after the outbreak of the pandemic, have seen purchases in excess of their capital key allotments (see Chart 5). In contrast, few French government bonds have been purchased reflecting much tighter yield spreads over German Bunds. 

Chart 5. PEPP breakdown at the end of May

Source: ECB and EFGAM calculations. 

The PEPP and the German Constitutional Court

Finally, it cannot be excluded that the Governing Council decided to aggressively increase the PEPP partly to assert its independence from the recent decision of the German Constitutional Court on the PSPP. After all, in the two months since the PEPP began, only about EUR235bn of the EUR750bn capacity has been used. Therefore, the ECB had plenty of room to implement its planned monetary stimulus without increasing the size of the PEPP.

President Lagarde took advantage of the Q&A session during the press conference to highlight two important issues related to the German Constitutional Court's ruling.

The first is that the ECB is subject to the European Court of Justice, which has already ruled that the PSPP is in line with the ECB's mandate. The second aspect, more focused on the observations of the German Court, is that before any monetary policy decision the Governing Council considers the costs and benefits of all available options and that a detailed summary of the debate is always reported in the accounts of the meetings.


The increase in the size and duration of the ECB’s PEPP reflects a sharp increase in euro area output and price gaps, the latter defined as the difference between the actual price index level and that consistent with the definition of price stability. The decisions taken by the ECB Governing Council also suggest that interest rates will be negative for several more years.

The Governing Council signalled its commitment to fulfil its price stability mandate and to counter the risks of financial fragmentation within the euro area. Moreover, it cannot be excluded that it also intended to dispel any doubts that the recent German Constitutional Court ruling would limit its actions.

Whatever the ultimate reason behind the latest Governing Council decisions, they strengthen the independence and credibility of the ECB and will benefit the euro area economy.

1 The decisions were shared by a broad consensus within the Governing Council, which was unanimous on the need to increase monetary policy accommodation.

2 Given the high degree of uncertainty, the ECB also presented two alternative scenarios. In the mild scenario, the decline in GDP in 2020 is only 5.9% followed by a strong rebound in 2021 (6.8%) and robust growth in 2022 (2.2%). In the severe scenario, however, GDP falls 12.6% in 2020 and recovers weakly in 2021 (3.3%) and 2022 (3.8%).

3 Similar to GDP alternative scenarios, in the mild scenario inflation is higher than the baseline and lower in the severe scenario. However, even in the mild scenario, inflation is seen at 1.7% in 2022, still below the ECB’s inflation aim. 

4See Expanding the pandemic emergency purchase programme,