Following Draghi’s surprise announcement at his last press conference that the Governing Council was “comfortable with acting next time”, the main question around this week’s Governing Council meeting is not if there will be action, but what form that action will take.
With the ECB’s refi rate at just 25bps, and the depo rate at zero, the Governing Council is approaching the limits of conventional action. And it has become clear over recent months, most notably in Draghi’s Amsterdam speech, that the ECB has been looking increasingly beyond the conventional. The options seem to boil down to:
- A cut in both the refi and depo rates, taking the depo rate negative;
- Further LTRO(s);
- A programme of ABS purchases centred on SME financing, and;
- A broad-based asset purchase programme.
To take the last option first, Draghi has made it clear that large-scale asset purchases are contingent on a material weakening in the inflation outlook. To be sure, the near-term inflation outlook is very weak indeed. After reaching a 4½-year low of 0.5%Y/Y in March, we believe that headline inflation in May dropped back to 0.5%, following the small rise in April (the official flash estimate is released tomorrow). GDP growth in Q1 also turned out weaker than the ECB expected, at just 0.2%Q/Q. But these weak outturns appear unlikely to materially change the ECB’s medium-term view, especially since the unexpected weakness of inflation has largely been due to transitory factors such as energy and food prices. As such, while inflation of 1.0%Y/Y in 2014 is now beyond reach, a rate of 1.3% in 2015 and 1.5% in 2016, as the ECB was forecasting in March, remains plausible, not least given that the underlying assumptions regarding exchange rates and commodity prices have not changed significantly from March. And with the forecasts likely to be little changed, the case for a broad-based asset purchase programme is simply not strong enough to get through the Governing Council.
So, with an announcement of a broad-based QE programme looking highly unlikely, the Governing Council’s move this week looks set to centre on a reduction in the ECB’s interest rates. The case for a rate reduction, based on Draghi’s own criterion that such a move would be made in response to an unwarranted tightening of the policy stance, is admittedly fairly weak. While average EONIA rates have been on the rise in recent months, forward EONIA rates have fallen since the May meeting. The euro is also weaker, down around 1½% from where it stood ahead of the May ECB meeting. But, with inflation having come in lower than expected in recent months, it could be argued that the resulting rise in real rates has resulted in a tightening in the policy stance. And the Governing Council will be all too keenly aware that a failure to act would send the euro shooting back up. So, we expect that the deposit rate and refi rates will be cut by 10bps, to -10bps and 15bps respectively, so as to leave the rate corridor unchanged.
And the Governing Council seems set to supplement a reduction in interest rates with other measures. In particular, with lending continuing to fall - lending to corporates has been contracting at a rate of 3%Y/Y in recent months - a new, but conditional, LTRO is likely to be launched, possibly with a maturity of four years. Akin to the BoE’s Funding for Lending scheme, the ECB looks set to tie the provision of funding to banks increasing private sector lending.
But the launch of an ABS purchase programme, seemingly Draghi’s preferred response to the impairment in the monetary transmission mechanism caused by a damaged banking system, appears to be some way off. Last week’s joint discussion paper between the ECB and the BoE set out the numerous obstacles to the development of a sizeable and efficient securitisation market. And since the paper invites comments from interested parties by 4 July, any move from the ECB ahead of that would be premature. So, while a deep, liquid and transparent market for ABS will remain a medium-term objective, imminent ECB purchases of such securities appear highly unlikely.
So, Thursday looks set to provide another set of “baby steps” from the ECB. The move to a negative depo rate will be ground breaking for a major central bank, but is not going to prove transformative for the economy. Neither will a cut in the refi rate or a further LTRO. But the Governing Council will be hoping that these small steps will provide a further small boost to growth, while keeping a lid on the euro. And while QE will remain an option, its implementation will rely on a significant deterioration in the medium-term inflation and growth outlook, something that the euro area remains a long way from.