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The ECB's PEPP six months later

Europe
On the 10/02/20 at 1:34PM

by

Maria Luisa Matarrelli

Maria Luisa Matarrelli, head of developed and emerging government bonds & FX at Eurizon, on the lessons of the Pandemic Emergency Purchase Program so far and its evolution.
Maria Luisa Matarrelli, head of developed and emerging government bonds & FX at Eurizon
(Eurizon)

On March 26th the ECB launched the Pandemic Emergency Purchase Programme (PEPP), which now is €1.35trn heavy. Through the PEPP the ECB is temporarily buying bonds from the private and public sector to dampen the economic consequences of the Coronavirus pandemic. 

The main goals achieved with the PEPP the ECB

The PEPP was launched in March to address the increasing fragmentation risks among the euro area countries, and the disorderly tightening of financial conditions. Then in June 2020, it took on a second objective of helping the inflation rate to come back to the pre-pandemic path. The distinctive feature of the program in comparison to the traditional APP is the flexibility, not having to fulfil the capital key constraint. Furthermore, the PEPP holdings have been also excluded from the computation of the issuer limit (33% for sovereigns and 50% for supranational). This high degree of flexibility has allowed the ECB to be pre-emptive at the beginning of the program, not buying on a pre-set pace, but purchases have been done across different asset classes in accordance with the threats to the ECB mandate. The first goal of reducing fragmentation and allowing an orderly functioning of the market has been achieved: the level of 5 years and 10 years GDP Weighted Yield, a measure of the Euro area wide financial conditions are lower now than in March and are the lowest in the G4 space. Keeping the financial conditions easy has also helped to lower the borrowing cost of governments, allowing them to sustain the fiscal support that has proven extremely successful so far at sustaining household disposable incomes during the pandemic.

The main goals yet to be achieve

The second goal of PEPP, that was added on June by the president Ms Lagarde, was to fostering the euro area inflation rate to come back to the pre-pandemic path. The size was consistently increased with this new objective from €750bn to €1.35trn. It is too soon to give a judgement about this second goal: the pandemic has worsened the path of inflation and it is very difficult to extrapolate what could have been the behaviour of the inflation rate, without the ECB introducing PEPP. Looking at the change of the FED framework about inflation (Flexible Average Inflation Targeting), the perception is that the ECB is a bit behind the curve on the revision of the monetary policy strategy. Having introduced the PEPP as a monetary policy tool the ECB has been able to compensate the delay in the revision of the monetary policy framework with a pragmatic approach: PEPP allows the ECB to buy flexibly across time, jurisdictions e asset classes.

The learnings of the PEPP

The launch of the PEPP and the frontloading of buying with significative deviations from the capital key changed the perception about the central bank behaviour. The investors have been used to see a reactive attitude to systemic stress phases. The PEPP flexibility has allowed the central bank to seem more pre-emptive, frontloading the buying program in the most critical phase and slowing the pace in the last weeks, when there is less urgency. The flexibility element is essential for the credibility of the central bank to ensure policy transmission to boost growth and inflation.  

Long-term consequence of PEPP in terms of productivity and profit margins

The corporate bonds holdings are a very small part of the PEPP (4%) that has been focused so far more on the government bonds sector. The ECB can only purchase corporate bonds (non-bank) with a first-best credit rating of BBB- across S&P, Fitch, Moody’s and DBRS, albeit purchase of high-yield bonds could be allowed, if one rating agency has a company rated as investment grade.

The announcement of the corporate program both in PEPP and the in traditional APP program has been very useful in lowering the borrowing cost of the corporate sector, avoiding a credit crunch that could cause a most dramatic plunge of the economic activity as happened after the Great Financial Crisis.  The coronavirus pandemic is an exogenous shock that could cause a funding pressure, worsening the general situation with an increasing of the default rate. The ECB has decided to adopt a series of tools in a general strategy of credit easing: the PEPP’s deviation from the capital key, the cheap pricing of the TLTRO and the corporate bond programs.  All these tools have been very useful in stabilizing the funding conditions.

The expected future for PEPPs

The general context of low potential growth and low inflation ensures that the main central banks around the world are going to pursue a strategy of suppressing the volatility of interest rate and keeping the liquidity conditions very easy. The quantitative easing strategies are an essential part of the central bank’s toolkit and are going to be used massively, given that the monetary policy rate is at the lower bound globally.

The European central bank has already shown a sort of reluctance in cutting the deposit rate more in deeply negative territory, so it is very likely that if the inflation rate will be far from the pre-pandemic path on June 2021, the PEPP will be extended.