ECB: Cutting But Not Surprising

The ECB did not surprise markets this week. As widely expected, the Bank cut the refi rate by 25bp, leaving the interest rate on deposit facility at 0%. Yet, the ECB left the door open for further actions on interest rates, should conditions deteriorate.
The poor state of the economy probably would have justified a bolder action, with a cut of at least by 50 bp.

Recently released data confirm that the eurozone patient remains sick. Not only did activity keep contracting in the first quarter of the year, but early survey data for the second quarter showed that confidence continued to deteriorate. Levels of leading indicators are quite low by historical standards, suggesting that a return to growth in the short-run is unlikely. More alarmingly, Germany, the eurozone's main engine, is running out of steam. Contracting activity in peripheral countries combined with sluggish growth in core countries jeopardize the ECB’s view that the eurozone might return to growth in the second half of the year.

In regards to prices, the ECB risks overshooting its target. Inflation is well below the 2% ceiling target. In April, it fell to 1.2%, from 1.7% in March and 2% at the beginning of the year. Methodological changes on how to treat some items of the HICP basket might have added some volatility, as did the sharp decline in energy prices. The economy's slack is clearly biting. Inflation might partially rebound going forwards, but it is on a downward trend. According to its latest projections (released in early March), the ECB forecasts inflation at 1.3% in 2014. Downside risks to this scenario have probably increased.

Against this backdrop, the ECB opted for a 25bp refi cut. The Council did not close the door to further cuts. First of all, while the prevailing view in the Council was for a cut of 25bp, the discussion went also on cutting by a larger amount. In addition, President Draghi re-affirmed that “the ECB was ready to act”, a sentence which suggests that 0.50% probably is not the lower bound for the refi rate.

A refi rate cut will clearly help all those banks which still heavily rely on the ECB liquidity, mainly banks from peripheral countries. By contrast, the impact on the yield curve will be lower, as the DFR, which under the current refinancing framework of “full allotment-fixed rate” has become the key policy rate signalling the ECB monetary policy stance, was left unchanged.

BY Clemente DE LUCIA

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