Even before the European Central Bank’s last meeting and the most recent data, we had for all practical purposes ruled out both a cut in February and an ease in March as well without further evidence of economic weakness or money market stress (see SGH 1/28/14, “ECB: Needing More Evidence to Ease”).
Indeed, our sense remains that while the February inflation reading was uncomfortably low, the more upbeat data on growth and even the inflation figures have, if anything, validated the ECB’s December forecasts, and we do not expect major revisions to their forecasts in March.
*** Nonetheless, our understanding is that ECB officials are well aware that these forecasts depend to a large part on an ECB that will keep monetary policy highly accommodative for as long as needed. Furthermore, a good deal of the anchoring of rate expectations and their forward policy guidance does, in fact, result from expectations that the ECB may be ready to follow through with further action from here. ***
*** And so, with downside risks still high, and broad consensus within the Governing Council to take further action if needed, the bar to a cut at this meeting is being set extremely low, and we assign a strong probability to some form of easing by the ECB at this meeting to reinforce their commitment to keeping rates low or lower for as long as necessary. ***
*** A rate cut is very likely to be discussed but may be seen as a blunter instrument than some of the other liquidity measures, and will depend to a larger extent on the magnitude of the adjustments to the longer-term forecast. Measures on the liquidity side appear to be highly likely. At an absolute minimum, the ECB will continue to keep the door wide open to further easing if needed, with little to no dissent from within. ***
Weak Data, but Broadly Validating Forecasts
Without a doubt, the debate on how to ease further if needed within the ECB is alive and well.
Eurozone inflation is clearly too low, including the most recent, dismal, 0.7% January reading, and the ECB has affirmed its symmetric commitment to responding to both downside and upside threats to its inflation target of “at or slightly below 2%.”
And even if inflation were to stabilize as expected, there are clear dangers if low inflation were to persist for too long, and the ECB has stated in no uncertain terms it will remain alert to those risks as well, and if needed, respond.
But last November’s cuts were taken already in response to the expected weak December quarterly ECB staff forecasts, cuts whose effects, as ECB President Mario Draghi reinforced in his last post meeting press conference, will be felt with a lag, and, even more importantly, already factored in inflation that was expected to remain low “at around current levels in the coming months.”
In other words, much of the current, and even some future, expected weakness was already factored into the prior November cut.
In fact, the press, and markets, missed perhaps the key takeaway from the sharp downward inflation forecast revisions by the ECB Survey of Professional Forecasters last Thursday. And that was that rather than serving as a harbinger of sharp revisions to come from the ECB itself in March, the forecasters were merely catching up to where the ECB already was back in December, and with the benefit of two additional months of data.
Specifically, the 2014 estimates for both are now exactly the same, at 1.1%, and the ECB was even a bit more cautious than the Professional survey in its forecast for 2015 inflation – expecting 1.3% versus 1.4%.
For this year, importantly, the ECB inflation forecast has also already assumed an outsized, strongly negative, year-on-year base effect adjustment for energy for the first two months of this year, one which will gradually stabilize and turn to a positive adjustment for the second half of the year.
The professional forecasters also gave a potential glimpse into the new, longer run, 2016 ECB forecasts that will now be released in March. They came out below the ECB’s target of at or below 2%, but only by a hair, at 1.7%, with very long run expectations holding at the nirvana-like level of 1.9%.
If the ECB follows through with a similar forecast for 2016, even if not a disaster, in light of other downside risks, that should, we believe, open the door to discussion of the merits further easing measures.
But as we also noted, (see again SGH 1/28, “Needing more Evidence…”), and Draghi himself noted, a good deal of the ongoing disinflationary pressures stem from price adjustments in the four program countries: Spain, Portugal, Greece, and Ireland. (Spain appears to be the biggest driver to the negative pull on the Eurozone. Greece is worse, but its economy is much smaller).
The significance of that for monetary policy is that if those disinflationary forces stabilize or do not dive further, a good portion of the weakness to date will have been due to adjustments in relative prices and competitiveness that were in fact a necessary, albeit harsh, by-product of the much needed fiscal clean-up of peripheral Europe.
Some ECB officials are therefore now starting to also hint that perhaps the ECB may want to take a slightly longer term view on inflation than usual due to the effect of these important structural adjustments.
Draghi has also emphasized two other points that we believe are new and significant in putting low Eurozone inflation in context.
The first is in comparing the current low inflation rates to European inflation behavior in the aftermath of two previous recent downside shocks: the period after the 2008 Lehman collapse as well as the period after the 1997-8 Asian financial crisis. Although the current disinflationary pressures have persisted for some time now, in both of those previous cases inflation did in fact gradually recover, along with the growth recovery cycle.
And second, Draghi has framed Europe’s low inflation in the broader context of global disinflationary pressures. In theory, that could cause the ECB to counter global (such as EM driven), and structural (such as DM demographic driven) components that still need to be better understood.
On the cyclical side, growth of course has been shaping up if anything to be a modest, positive surprise. Anemic economic activity, and in certain countries over 25% youth unemployment rates, can certainly, if prolonged, exacerbate already dangerous disinflationary forces, not to say crush the Eurozone’s economy and social fabric.
But the latest 2013 Q4 GDP numbers, rising from 0.1% in Q3 to 0.3%, is a recovery we had been told to expect, and has validated some signs of at least tentative stabilization, if not acceleration. That includes not just in Germany, but especially even in program countries, that means Spain, and in France. Even Italy has posted its first positive quarterly GDP number since the second quarter of 2011.
On Money-markets, and With Little to Lose
But the risks nevertheless are real and remain, especially if inflation were to go lower or stay low for longer than expected, and so Draghi and other senior ECB officials have also therefore reiterated on numerous occasions that the ECB is ready to act to reverse any unwarranted market rate creep or stress that would counter its forward policy commitment to keep rates low or lower for as long as needed.
So far, most of the European money market “stress” that the market has gotten so worked up over is in fact modest and, more accurately, has been limited to some volatility in the front end of markets.
And obviously the short end matters, but as we have also noted before the all-important medium term rate expectations and pricing have also remained anchored. And there has been no sign of any challenge whatsoever to the ECB’s Forward Policy Guidance, whose almost unexpected success in managing rate expectations (undoubtedly aided by anemic numbers) is in contrast to some of the challenges the Fed has recently faced, and may face again, assuming US growth picks back up again as expected.
And finally, some of that short term tightness in liquidity, you will recall, was being seen by the ECB to stem from the shrinkage in the bank balance sheets and a “clean up” in advance of the all-important Asset Quality Review and ECB bank Stress Test.
Nevertheless, ECB officials are well aware that a good deal of the anchoring of their guidance is due to expectations that the ECB will indeed follow up with liquidity measures, if not cuts, if and when needed.
And with downside risks still there, the Euro still creeping up, and no guarantee that US rates will not pull the average EONIA curve up to the 25 basis point Refi (MRO) rate, and more importantly, perhaps with it pull up longer rate expectations, we sense that the ECB may be readying for some sort of action at this meeting.
In other words, with little or nothing to lose by acting, the bar to delivering on something is being set extremely low within the Governing Council for the March meeting.
Different Options for Different Risks
We have long maintained that as banks return LTRO (three-year, long-term) borrowed funds to the central bank, a sign of normalization indeed, there is a certain balance sheet level that the ECB will nevertheless try to maintain.
But we expect the ECB to first choose to address those specific liquidity issues with more traditional short date liquidity operations or even medium term injections (MTROs), and ECB officials still consider their “fixed-rate, full allotment” facilities to be one of the most powerful tools at their disposal.
Utilizing their extremely limited room for a small tweak down in the refi rate from 25 to 10 or 15 basis points, much more entering into the experimental zone of a small negative deposit interest rate, as many expect, would be more powerful, but could also raise questions over potential unintended consequences, as always, and signaling effects. We nevertheless do not rule it out.
Injecting liquidity by not sterilizing the roughly 175 billion Euros of SMP purchases of government bonds on the ECB’s balance sheet is one of the other liquidity options often discussed, and mentioned early on by us as one of the weapons in the ECB’s arsenal, and one we believe that is very likely.
The German Bundesbank just made some headlines yesterday in essentially giving the green light to this option, which may seem curious to some as the BUBA is and has long been the bastion of resistance to any government bond purchases whatsoever, including the SMP program, and one would assume with it any non-sterilization of that which could open the door to any thoughts of a “QE” program.
But in fact, as explained to us, the BUBA is wishing to make the distinction here that while it indeed has not and never will endorse the original program of SMP bond purchases (or the OMT program), that resistance is exactly over the prohibition of purchases of bonds to monetize government debt, an over-step into fiscal policy. Now that the bonds are already on the ECB balance sheet, what it does with sterilization is purely a matter of monetary policy, and fully within its mandate.
Tougher Options and the Long Arm of the Law
Efforts to develop a new corporate bond plan or an SME backed ABS market which the ECB could participate in are nothing new (do a Google search on “SME Plan”), but will take a long time to develop, if ever. It is and has been a great idea, but even Draghi himself has pointedly referred to it as not more than consideration of a “Vanilla type ABS” plan.
A corporate bond purchase plan may ease conditions for a large corporate sector that is already in relatively good shape, but its size would still be limited, (far smaller than government bonds) and translating that to the small business (SME) ABS segment that really needs the stimulus has proven extremely challenging to date.
In the case of extreme duress or, as we like to call it, “breaking the glass,” there is, finally, the big Kahuna: the option of large scale ECB purchases of government bonds.
Of course the ECB has long maintained it is permitted to purchase government bonds in the secondary market, and the ECB has done so (SMP) and threatened to do so (OMT), but only when “within its mandate” and when it does not break the explicit prohibition in Article 123 of the EU Treaty of any direct financing of government debt.
While that may seem reassuring to hawks, it does leave open the ever so subtle and subjective caveat of “when exactly” government bond purchases could be interpreted as financing government debt, rather than, say, easing transmission mechanisms or preventing the breakup of the Euro.
But that is a hypothetical question conveniently left for an entirely different time and place, and we do not expect there to be a reason or appetite to test those limits, if ever, until well after the Court of Justice of the European Union rules on the OMT challenge. It will certainly not be an option or issue for this meeting.