By David Barwick – FRANKFURT (EconoStream) – When the European Central Bank recalibrates its policy stance next month, it will probably rely chiefly on its pandemic emergency purchase programme (PEPP) and targeted longer-term refinancing operations (TLTROs) in doing so, ECB President Christine Lagarde said Wednesday.

Speaking at the ECB Forum on Central Banking 2020, Lagarde, according to a text of her remarks made available by the ECB, said however that all options are open to consideration.

‘In the weeks to come we will have more information on which to base our decision about this recalibration, including more evidence on the success of the new lockdown measures in containing the virus, a new set of macroeconomic projections and more clarity on fiscal plans and the prospects for vaccine roll-outs’, she said.

She continued: ‘While all options are on the table, the PEPP and TLTROs have proven their effectiveness in the current environment and can be dynamically adjusted to react to how the pandemic evolves. They are therefore likely to remain the main tools for adjusting our monetary policy.’

That downside risks to economic developments have become greater is clear, she said. The pandemic’s impact ‘is now likely to continue to weigh on economic activity well into 2021’, she affirmed. Inflation, she said, ‘is expected to remain in negative territory for longer than previously thought.’

Although the persistence of negative inflation is due partly to passing effects, the weakness of underlying inflation is apparently related to the reduction of economic activity, she said. Moreover, exchange rate developments ‘may have a negative impact on the path of inflation’, she added.

Policy support remains necessary in the pursuit of price stability, she said, but it is more difficult than normal to predict what path inflation will take. Supply-side constraints leading to consumption shifts are causing ‘significant noise’ in the data, she said, while the ‘stop-start nature of the recovery’ is creating high uncertainty.

Monetary policy has to support demand and prevent second-round effects, she said. ‘To that end, the best contribution monetary policy can make is to ensure favourable financing conditions for the whole economy’, she said

An important consideration for the ECB is the need for monetary policy to minimise crowding-out effects by which fiscal policy could boost market interest rates, discouraging private investment and dampening demand she said. At the same time, monetary policy has to continue to support banks so as to safeguard the transmission mechanism and prevent adverse feedback loops, she said.

‘Firms are still dependent on new flows of credit’, she said. ‘And those that have borrowed heavily so far need certainty that refinancing will remain available on attractive terms in order to avoid excessive deleveraging.’

This implies that how long policy will remain supportive matters, she said: ‘All sectors of the economy need to have confidence that financing conditions will remain exceptionally favourable for as long as needed – especially as the economic impact of the pandemic will now extend well into next year.’

To ensure continued favourable financing conditions, the ECB will recalibrate its instruments, she reminded. ‘The Council is unanimous in its commitment to ensure that financing conditions remain favourable to support economic activity and counteract the negative impact of the pandemic on the projected inflation path’, she reiterated.

Lagarde said that the recovery ‘could well be bumpy’, noting that the ‘strong resurgence of the virus … has introduced a new dynamic.’ Progress towards a medical solution to the pandemic ‘looks encouraging’, she said, but ‘we could still face recurring cycles of accelerating viral spread and tightening restrictions until widespread immunity is achieved.’

The services sector had already been slowing before the second wave led to new containment measures, and ‘there is a risk of the recovery in manufacturing also slowing once order backlogs are run down and industrial output becomes better aligned with demand’, she said.

‘In this situation, the key challenge for policymakers will be to bridge the gap until vaccination is well advanced and the recovery can build its own momentum’, she said.

The vigorous economic rebound last quarter confirms the efficacy of the initial policy response and that the economy can still recover, she said. ‘But it will require very careful policy management to ensure that this remains the case’, she added.

In particular, the economic slump cannot be allowed to become a typical, self-propagating recession, she said. The second wave of Covid-19 thus ‘poses no less danger to the economy’, she said, because economic agents could start making worries about the future a more durable basis for their behaviour.

The ECB’s bank lending survey suggests bank credit standards could tighten in the coming months, she said. ‘We are also seeing indications that small and medium-sized firms are expecting their access to finance to deteriorate’, she said.