ECB: Back in Play

Published on November 5, 2013

The latest release of Eurozone inflation readings on October 31, showing a collapse in the headline rate from 1.1% to 0.7% and in core inflation from 1.0% to 0.8%, has led to a flurry of speculation in the street and among analysts on if, when, and how the European Central Bank might further loosen monetary policy.

But with the release of those numbers having come so close to the upcoming monthly Governing Council meeting on Thursday, November 7, little of that speculation reflects the thinking of ECB officials who will be debating that decision, due to their strict adherence to a one-week blackout on communications on monetary policy, or “purdah,” before these monthly meetings.

This is our assessment of the most probable response from the ECB:

*** While the ECB has been and probably remains loath to take actions that would conflict with its message of a gradual recovery in the Eurozone, inflation has been far enough below its 2% target for long enough, and this latest drop is sharp enough (even though it is likely to be the trough and is in large part energy related), that it will lead the ECB to lower certainly its 2013 but also its 1.3% 2014 inflation forecast at the upcoming December quarterly forecast round, which will also include 2016 forecasts for the first time. ***

*** President Mario Draghi is therefore highly likely – at a minimum, we believe – to signal a downside risk to the ECB’s inflation assessment and forecast at this meeting, which would tee the Council up for what would very likely be a 25 basis point cut in the refi rate from 0.50% to 025% in December (without a drop in the deposit rate into negative territory). Part of the discussion on the drop in inflation will be to point out that it is not entirely negative – lower energy inflation increases the purchasing power of consumers – but the drop in inflation has nevertheless now been deeper and broader than just energy related. ***

*** And while not our base case scenario, we would even assign some reasonable probability that the Council may decide to go ahead and cut the refi tomorrow anyway, rather than wait for the forecast round in December, given that the risks, merits and possibility of an interest rate cut have already been discussed – on and off – ad nauseum by the Governing Council, even if sporadically, now for months. ***

And as a side note on markets, we would disagree with the idea now being touted by some Euro bulls that a refi cut would be bullish for the Euro. For one, even if a cut is now, to some degree, priced into the interest rate strip, a modest cut in rates may not engender the type of rally in confidence or influx of foreign investment into Europe that would lead to a sustained bull run in the currency.

Secondly, the ECB would go to great lengths to make sure that it leaves no doubt – even to a skeptical market – that it will still have further options left at its disposal if needed even after a cut in the refi to 25 basis points. And finally, timing-wise, an actual cut, were it to come tomorrow, would be a very big surprise for markets indeed, and even alternatively the clarity of a downward bias pointing to a move in December would still eliminate a lot of doubts on ECB policy lingering over markets.

Stimulating Discussions

Our understanding is that through the course of this year, Draghi himself has, on occasion, been sympathetic to the possibility of cutting rates further. To date, however, he has held off in the face of still mixed data reinforcing a base case modest recovery forecast, assurances that inflation expectations have remained anchored, and council members that were somewhat hesitant at the time to cut further.

Furthermore, the ECB seems far less concerned over potential complications to money markets if the refi rate were to be cut from 50 to 25 basis points without the more controversial cut in the deposit rate floor from zero into negative territory. In other words, collapsing the operating rate corridor from the more tradition 75-100 basis points to a mere 25 basis points will not deter a refi rate cut if deemed necessary.

And in fact, the option of collapsing the rate corridor through a refi cut was given consideration at the July 4meeting, when Draghi ended up rolling out the ECB’s “commitment to low rates,” as a means of further anchoring forward market pricing and expectations. It was, however, substituted in the end instead with the addition of “or lower” to the commitment on low rates, as a compromise (see SGH 9/27/13, “ECB: Reinforcing Forward Rate Guidance”).

In the ensuing months, the ECB has also studied the pros and cons of various new LTRO liquidity injection options, even though banks have been returning loans.

These conditional planning studies have been conducted mainly in preparation for the possibility of an unwarranted creep up in interbank rates either due to the upcoming EBA/ECB Asset Quality Review (AQR) or ECB stress test (not, obviously, to bail out any individual banks), or if rates were to creep up due to other unwarranted extraneous factors, such as another Fed taper scare.

ECB officials remain open to another LTRO operation if needed, but we believe that would, at this point, most probably be kept in reserve.

When it comes to the Euro exchange rate, the message from the ECB is and will continue to be consistent and non-controversial: The ECB does not target the Euro exchange rate, but that obviously does not mean it does not matter, as it is a key input into the central bank’s inflation forecast.

And with inflation already running low and so much of the Eurozone – especially southern European – recovery still reliant on export growth, the Euro will certainly remain a significant input for some time.

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