Read for 5 minutes Reuters – FRANKFURT (Reuters) – The European Central Bank, like the Federal Reserve of the United States and other major central banks around the world, has pumped unprecedented amounts of emergency stimulus into the economy to help firms and households weather the pandemic. PHOTO FROM THE FILE: On March 7, 2018, the European Central Bank (ECB) headquarters building is seen in Frankfurt, Germany. REUTERS/File Photo/Ralph Orlowski As activity picks up, it must now decide when to begin reducing that support. Acting too soon risks suffocating the economy, while acting too late risks overheating and governments becoming complacent about their already high debt levels. In the weeks and months ahead, the following analyses the important subjects in the debate as well as the sticking points that will emerge between the various parties in the 25-member Governing Council. WHAT EXACTLY IS A CRISIS? The ECB’s 1.85 trillion euro emergency asset purchase program will run until the pandemic’s “crisis phase” is ended — a purposely vague, ambiguous phrase that allows the bank plenty of leeway and discussion. The crisis will be finished for German Bundesbank President Jens Weidmann, one of the euro zone’s most conservative officials, if the economy returns to pre-pandemic proportions, which is projected in the first quarter of next year. ECB board member Fabio Panetta, on the other hand, believes the bank should only withdraw after inflation and inflation expectations have returned to the bank’s aim. Then there are those in the center, who are policymakers. Some suggest that the crisis will be ended once the economy has recovered its two-year deficit, while others argue that the labor market, which typically lags any recovery, should be a major indicator. Investors presently expect the Pandemic Emergency Purchase Program (PEPP) to end in March, but ECB President Christine Lagarde has yet to make any firm statements on the subject. REVIEW The ECB is now finalizing the outcomes of its 18-month strategy review, which is likely to modify the inflation target and set some secondary targets, further complicating the discussion. Because the decision on when and how to end emergency stimulus is almost expected to be made only after the review, several of the criteria that will be used in the debate have yet to be identified. FLEXIBILITY Flexibility appears to be a major hurdle. Normally, the ECB is constrained by a slew of rules, many of which were thrown out during the epidemic to allow the ECB to respond to rapidly changing market conditions. These guidelines dictate, among other things, that bond purchases should be proportional to the size of each country’s economy rather than the size of its national debt, and that the ECB should purchase a pre-determined quantity of debt over a pre-determined period. It should also only purchase investment-grade bonds and not hold more than one-third of any country’s debt. These criteria make it more difficult to assist extremely indebted countries like Italy and Spain, as well as to purchase Greek bonds, whose debt is still classified as “junk.” Policy hawks argue that exceptional flexibility should only be used in times of crisis, whereas doves argue that these standards must be followed. A legal question is also raised in the debate. The European Central Bank’s non-emergency bond purchases have already been challenged in German and European courts, and the European Court of Justice upheld those schemes precisely because the intervention was limited. Any adjustments to such limits will almost certainly land the ECB in court again. ECB board member Isabel Schnabel hinted at a possible compromise when she said the bank “cannot simply transmit the complete flexibility” of the emergency scheme, leaving the option open to keep some but not all of it. ARE YOU READY TO RAMP UP? The ECB will still be undershooting its inflation objective after the emergency expires, therefore stimulus will have to continue. However, the scope of this support will be a hot topic of discussion. Several policymakers, like Francois Villeroy de Galhau, the head of the French central bank, have suggested that the ECB should focus on its long-running, more limited Asset Purchase Program, which is now worth 20 billion euros per month. However, even once the emergency purchases cease, markets are not pricing any increase in such purchases, and conservatives like Austria’s Robert Holzmann believe that these estimates are about right. The difficulty is that government and corporate debt issuance is expected to remain high next year, so reverting to pre-crisis stimulus levels would result in the ECB retreating and borrowing costs rising. TAPERINGWhen ECB support is withdrawn, there should be no “cliff effect.” However, as March approaches, Weidmann’s slow withdrawal would force the ECB to begin decreasing purchases as early as the fourth quarter. However, such a move would raise borrowing costs. The ECB’s policy doves argue that the economy isn’t ready for that, because governments would emerge from the crisis with high debt levels, and even tiny increases in borrowing costs will have an impact on public finances. Balazs Koranyi contributed reporting, and Catherine Evans edited the piece./nRead More