Given the ECB’s aim to keep inflation “close to, but below, 2%” over the medium term, and with Draghi and his colleagues having repeatedly pledged to guard against a prolonged period of excessively low inflation, the steeper-than-expected decline in euro area CPI to a 4½-year low of 0.5%Y/Y in March and the weak April flash CPI estimate arguably demand a policy response. But when it meets tomorrow, the Governing Council looks to have enough excuses to continue to sit tight.

ECB to play a waiting game?

First and foremost for the Governing Council, dramatic as March’s drop in inflation was, there are sound reasons to expect it to represent the trough. It was artificially depressed (by around ¼ ppt.) by the timing of Easter this year and last, whose effect reversed in April. And while the rebound in April, to 0.7%Y/Y, surprised on the downside, this was mainly down to an unusual and likely temporary drop in food prices, with the strong euro also playing a role. April’s reading certainly leaves the ECB’s most recent inflation forecast of 1.0%Y/Y in Q2 in need of a downward revision when it is updated next month. But we suspect the Governing Council will keep its fingers crossed that the strengthening economic recovery – which has so far been as firm as it would have dared hope and looks set to continue – will increasingly work in its favour to push core inflation higher by the end of the year.

Non-negligible risks of deflation remain

We agree that inflation is more likely than not to move broadly sideways over coming months before picking up by year-end. But despite firmer growth, the risks remain skewed to the downside. Unless and until inflation moves significantly higher, the euro area will remain vulnerable to the kind of ‘accidental’ slide into deflation that Japan experienced. And if that were to happen, it is difficult to imagine the ECB ever being willing to undertake the kind of massive monetary expansion now underway at the BoJ that would then be required to remedy the situation. It would arguably be in the ECB’s best interests to take further measured action now to ensure that it never has to face such a scenario.

Unpredictable consequences of easing options

The Governing Council’s institutional risk aversion is one reason for our view that it will do nothing. Members will feel uneasy that the policy options now available are unorthodox, with unpredictable consequences. ‘Conventional’ easing via further rate cuts would imply entering the uncharted territory of a negative deposit rate. Yet the Governing Council probably feels that further cuts would not materially lift the inflation outlook. And ‘traditional’ QE via purchases of government bonds seems bound to remain very much a last resort. Certainly, the hurdle for action from the Governing Council seems higher now that orthodox policy options have been exhausted – it is likely to be unwilling to act without incontrovertible evidence that its current policy stance is too tight.  

Defending the current monetary policy stance

But a deteriorating inflation (or, for that matter, growth) outlook is not the only potential trigger for further ECB action. As Draghi made clear in his Amsterdam speech of 24 April, action might also be justified by a sudden unwarranted tightening in financial conditions. These could come via renewed significant euro appreciation, or sovereign bond or money market tensions. And the ECB could respond via rate cuts and/or new liquidity operations (including LTROs). A second source of tightening could be new (or even continued) impairments to the transmission of monetary policy to bank lending, which might call for a new LTRO or purchases of assets, including asset-backed securities (ABS).

Are there signs of a near-term tightening of financial conditions?

Like the downside surprises to inflation, we do not think financial conditions have evolved yet in a way that is likely to prompt the ECB to respond. To be sure, having already accounted for more than one third of the decline in inflation over the past year and a half, the euro has now hit its strongest level against the dollar in more than two years. And bank lending to firms continues to decline while the cost of loans at the periphery remains high. But periphery sovereign spreads have continued to compress to multi-year lows while government bond-market access has further improved,  enabling Portugal to join Ireland in a ‘clean’ exit from its bailout programme.  And while the recent downward trend in ECB excess liquidity poses a risk of an unwanted tightening of money market conditions, a massive net injection of liquidity via the ECB’s main refinancing operations at end-April helped to ease the most significant recent pressures and bring EONIA back below the refi rate at the start of May. Indeed, the ECB’s pledge to maintain full allotment in its main refinancing operations through to July 2015 diminishes the case for a new LTRO over the near term.

Looking beyond the near term

So, where does that leave ECB policy? Expect nothing this week -  the case for immediate easing simply does not appear to be compelling enough for most Governing Council members. But should another significant downside surprise arrive in the flash estimate of May inflation, possibly alongside a further marked strengthening of the euro, we would not rule out a further rate cut in June or beyond. This is not, however, in our central scenario. But that doesn’t mean that we don’t expect further ECB action. Since we expect credit growth to remain subdued and interest rates on loans to firms at the periphery to remain elevated, we think the Governing Council will ultimately launch purchases of ABS. But that will only come if and when the regulatory environment for the asset class has been reformed to facilitate a deeper and more liquid market. And, if introduced with sufficient vigour, this could have important implications for firms’ funding costs. But it would be a far cry from the QE bazooka that so many crave, but that the ECB looks as far away as ever from launching.

Our full assessment of the various policy options is set out in the table below:

 Source: Daiwa Capital Markets Europe Ltd