Weak Activity And Low Inflation Might Force The ECB To Act

At its June meeting, the ECB left key policy rate unchanged. The refi rate remains, thus, at its historical low of 0.5% and the deposit facility rate at 0%.

The Bank did not close the doors to further actions. President Draghi repeated that the Council was ready to act if needed, and that the Bank will monitor all developments very closely. We had the impression that in the absence of further deterioration, the ECB will leave key policy rates at the current levels. The ECB has released its new growth and inflation projections, which have been slightly decreased downwards this year and almost left unchanged for 2014. The Bank forecasts a recovery in the second half of the year, which should gain momentum throughout 2014. According to the Bank the downward revision of inflation came mainly from the decline in oil prices, while measures of inflation that exclude the most volatile components such as food and oil prices were broadly unchanged.

Expectations for an imminent move of the ECB, say within one month, have been scaled down. Admittedly, recent survey data have shown some incipient signs of improvement. Yet, this is far from announcing a significant and buoyant recovery any time soon. Consumption remains weak, constrained by fiscal consolidation measures and by tough labour market conditions (the unemployment rate is currently at 12.1%, the highest rate since the launch of the euro, a record likely to be broken going forwards). Low levels of confidence, combined with low capacity utilization and tough credit conditions, mainly in peripheral countries, are squeezing investment. Activity in the second quarter risks being as weak as in the first quarter: at best, the pace of contraction may have somewhat eased.

The eurozone could switch back to growth in the second half of the year, but the recovery will be everything but buoyant. The eurozone seems trapped in a kind of equilibrium characterized by low growth and decelerating inflation. A lot has been done to improve the governance of the EMU. Yet all these measures address to the long-run, while the short term continues to be painful for many countries. The recent decision of the European Commission to focus more on structural rather than nominal, deficit targets is welcome, as it provides countries with more time to adjust. Yet, the rooms of manoeuvre for fiscal authorities remain limited. By contrast, the ECB can rapidly undertake several actions to stimulate demand, boost confidence and improve further liquidity conditions. Banks in peripheral countries are still highly addicted to ECB liquidity. The spread between the refi rate and the Eonia is close to 50bp, which means that funding costs for banks in the peripheral and core countries are highly different and consequently the interest rates on loans to non-financial corporations are much higher in peripheral than in core countries. Yet, this is not the only element explaining the differences in banks’ retail rates from one country to another. Counterpart risks are much higher in peripheral than in core countries. Nevertheless liquidity constraints play a crucial role, something that the ECB can ease.

What kind of policy beyond a refi rate cut?
Bolder actions similar to those undertaken by the Bank of Japan and the Fed would probably be needed to push the eurozone out of its sub-optimal equilibrium. Yet, political vetoes and moral hazard issues will prevent the Bank from massively intervene in sovereign debt market. Actions outside the perimeter fixed by the OMT are highly unlikely.

Yet, President Draghi stressed that the Bank is be ready to undertake further actions if needed. The ECB is indeed technically ready to cut into negative territory the interest rate on deposit facility. There are pros and cons regarding this measure. In particular, a negative deposit facility rate might induce banks to use the liquidity borrowed from the ECB for loan distribution or asset purchases rather than leaving it parked at the ECB. In addition, it could have a much larger impact on the exchange rate than a mere refi rate cut. On the other side, it could trigger a significant reduction in excess liquidity causing a tightening of credit conditions, something that the eurozone does not need at all. In addition, it could affect banks’ profitability, forcing them to raise retail rates with negative effects on the volume of credit growth. Lastly the cost of this operation risks to be unevenly supported from one country to the another as the main users of the deposit facility are banks from core countries, mainly from Germany, Luxembourg and Finland, and this element might create some tensions within the council.

The discussions with the European Investment Bank regarding actions to stimulate lending to SMEs continue, but President Draghi stressed that, on this point, a solution is far from having been reached. Last but not least, the Council discussed the possibility of adopting a forward-guidance rule regarding interest rates as done, for instance, by the Fed. The ECB currently use the sentence that “the monetary policy will remain accommodative as long as needed”. However, this statement refers mainly to the liquidity providing operations, while, for the time being, there is no reference the interest rates. A commitment on interest rates might have a significant impact on expectations, exchange rates, the yield curve and eventually growth.

The article 127 of the Treaty on the European Union says that the primary objective of the ECB is to maintain price stability. Without prejudice to this objective the ECB can conduct policy aiming, among other things, to promote balanced economic growth, full employment etc. With inflation projected to be well below its target (inflation close but below 2%) this year and next, the ECB has room of manoeuvre to take further actions.

BY Clemente DE LUCIA