By Dhara Ranasinghe and Ritvik Carvalho
LONDON (Reuters) - For the first time in months, the European Central Bank has reason to break from crisis-fighting mode -- economic activity is picking up after the COVID-19 hit, markets are stable and agreement on an European recovery fund appears close.
Yet the future is uncertain and Thursday's meeting could see lively debate on what's next for the emergency bond buying programme it ramped up in June.
"We're getting to the third phase of the crisis response," Commerzbank head of rates and credit research Christoph Rieger, said. "The first phase saw the ECB in denial, the second phase was a 'whatever it takes' moment. The third phase is about reflection."
Here are five key questions for markets.
1. What will the ECB discuss?
ECB chief economist Philip Lane recently suggested the bank is on hold after delivering stimulus three times this year.
Its emergency asset purchases should cover this year's jump in net euro zone sovereign bond issuance, estimated at around 600 billion euros after redemptions.
So it may now review those purchases and the degree of flexibility that should be applied in coming months.
While pressure for more stimulus has eased, expect the ECB to keep a dovish tone.
Graphic - The ECB's QE programme https://fingfx.thomsonreuters.com/gfx/mkt/qzjpqeleapx/Pasted%20image%201594378027120.png
2. Could the ECB hold back spending the whole PEPP envelope?
As the economy stabilises, some ECB board members have suggested the entire Pandemic Emergency Purchase Programme "envelope" - recently boosted to 1.35 trillion euros ($1.52 trillion) - might not be spent.
The challenge for ECB chief Christine Lagarde is to acknowledge that data is improving but reiterate her strong commitment to stimulus, given the full extent of unemployment and corporate bankruptcies may become clear only later.
"Not to do so would be damaging for markets and ECB credibility," says ING senior rates strategist Antoine Bouvet.
The Italian/German 10-year bond-yield gap narrowed sharply after June's aggressive action, stabilising around 170 bps.
Graphic - Euro zone bond markets during the coronavirus crisis https://fingfx.thomsonreuters.com/gfx/mkt/bdwvkamakvm/Pasted%20image%201594377945248.png
3. How is growth and inflation faring against ECB expectations?
The ECB expects the economy to shrink by 8.7% in 2020 before growing 5.2% in 2021, and Lagarde reckons the worst is "probably past".
Inflation is projected at or near zero for the rest of 2020, but the ECB might take comfort from a long-term market-based inflation gauge rising back above 1%, even if it's below the near-2% target.
Annual inflation accelerated to 0.3% in June from just 0.1% in May, supporting ECB expectations that a negative reading may be avoided.
Graphic - Euro zone inflation expectations perk up https://fingfx.thomsonreuters.com/gfx/mkt/xklpyzrznvg/Pasted%20image%201594377802976.png
4. Could TLTROs become a more permanent part of the toolkit?
Possibly. Banks borrowed a record 1.31 trillion euros at last month's ECB offering of cheap, long-term loans. Some believe that mortgage loans might be included in future TLTROs.
Launched six yeas ago, targeted-longer term refinancing operations were redesigned this year, allowing banks cash at rates as low as minus 1%.
Markets are also keen to hear whether the multiplier on tiered rates could rise. This exempts banks from an effective penalty due to negative rates on excess reserves at the ECB. Any action here will likely be linked to the deposit rate, which is unlikely to be cut again soon.
"For now, the ECB may consider that it has already been very generous to banks via the TLTRO," said Anatoli Annenkov, senior European economist at Societe Generale.
Graphic - ECB Long-Term Refinancing Operations https://fingfx.thomsonreuters.com/gfx/mkt/azgporblkvd/ecbTLTRO2406.PNG
5. Could the ECB buy more supranational debt?
With EU leaders meeting on July 17-18 to reach agreement on a 750 billion-euro recovery fund, the ECB could be asked if it will lift the share of supranational bonds it buys, currently at 10% for public sector purchases.
The European Investment Bank currently accounts for 43% of the ECB-eligible pool of supranational debt. But the EU could overtake that, even if the recovery fund proposal is watered down.
Graphic - PSPP-eligible Supranational pool PSPP-eligible Supranational pool https://graphics.reuters.com/EUROPE-MARKETS/ygdpzweazvw/chart.png
(Reporting by Dhara Ranasinghe; Graphics by Ritvik Carvalho; Editing by Toby Chopra)