European Central Bank set to increase its stimulus as Covid lockdowns blight the economic recovery

The European Central Bank is set to expand its massive stimulus program Thursday as the continent deals with a second wave of the coronavirus pandemic and associated lockdowns.

Back in October, the euro zone’s central bank vowed to “recalibrate its instruments” at its December meeting to respond to the “unfolding situation.” Shortly afterward, new virus lockdowns across the region dented the economic outlook significantly, at least in the short term, as daily infection rates surged. So far, the ECB has refrained from showing too much optimism on the rollout of vaccine candidates, with inoculations likely to begin early next year  

“The near term outlook remains abysmal, and the ECB will want to keep its focus on the short-term pitfalls until a clearer end to the pandemic is in sight,” Societe Generale ECB watcher Anatoli Annenkov said in a research note. 

Annenkov and SocGen expect an extension of the ECB”s bond-buying program until December 2021, with an extra 600 billion euros in total, alongside a new financing program for banks. 

While the vaccines may well be a game changer for the globe next year, the ECB seems to be erring on the side of caution. The so-called central bank of the central banks, the Bank of International Settlements, warned in its quarterly report on Monday about the risk of rising insolvencies.

“We are moving from the liquidity to the solvency phase of the crisis,” said Claudio Borio, head of the BIS monetary and economic department. 

“We should be expecting more bankruptcies going forward yet credit spreads are quite low by historical standards, and indeed while banks are pricing risk more carefully we don’t see the same in capital markets.”

The BIS has also advised central banks that doing too much is better than doing too little. 

The rising euro-dollar exchange rate is another headache for the ECB and its goal to boost inflation. The single currency has risen 8% against the greenback this year and is expected to stay strong for now. A high exchange rate can dampen the appetite for purchases from overseas, which then weighs on consumer price growth. 

So as well as the immediate firefighting, the ECB also has an even more difficult task to tackle: getting inflation back to its target of close to but below 2%. 

How it sees the inflation rate developing will be another important aspect of the meeting on Thursday. The ECB will publish its new staff projections and it’s expected to lift the growth outlook for next year slightly. But the inflation projections could see a slight downward revision.

“Amid the Q4 contraction of the economy the disinflationary trend continues,” Berenberg’s Florian Hense said in a research note. “We expect the ECB to lower its 2020 (inflation) call from 0.3% to 0.2% and its 2021 call from 1% to 0.9%.”

That’s far away from its target, and the new year could see a much more ambitious inflation target as the ECB ponders a shift in policy after its strategic review.